Small-cap stocks are sizzlers. These tiny titans have done much of the U.S. market's heavy lifting since the March 2009 low, more than doubling investors' money in some cases.
It's been a remarkable run, and good news if you had foresight. The bad news is that most people invest in hindsight.
now might be tempted to chase small-caps' hot returns, but be careful not to hop the last car of the train. The bull market is maturing, and leadership will likely shift towards higher-quality stocks with healthier finances and larger market values.
Small caps -- companies with market values of up to about $2 billion -- have come so far, so fast, investors shouldn't be surprised to see these shares give back a chunk of their gains.
"The small-cap rally has been great while it lasted," said Brian Belski, chief investment strategist at Oppenheimer Asset Management. "But the recent rally we've enjoyed in small-caps is running at a rate three standard deviations above the historical average; fundamentals don't support the upside."
Put simply, small-caps probably have seen their best days in this rally. Though shifts in market trends and sentiment can take several months or longer to play out, small-caps shouldn't be your first choice for new investment. And if small stocks are more prominent in your portfolio after almost 14 months of gains, it's never a mistake to take some profits. Small cap is likely poised for a pullback in the coming months as investors realign expectations," Belski told clients in a recent research report. "We maintain our underweight position on small-cap and urge investors to patiently wait for more reassuring fundamental news before adding any more exposure."
Swing and a miss
Strike one against small-caps is that they've made a ton of money in a short time.
RUT 729.37, +6.98, +0.97%
SPX 1,207, +15.82, +1.33%
20%10%0%-10%10FMASmall-cap stocks by nature are often lower quality and higher risk, and the shares of many of these companies were priced to go out of business during the 2008 meltdown. They survived, and their snapback returns look like accounting errors. The broad Russell 2000 Index /quotes/comstock/10u!i:rut (RUT 729.37, +6.98, +0.97%) is up 96% since March 9, 2009. So far this year, it's gained about 18%. The smaller Microcap Index has soared 101% and 21% over the same periods.
Market sectors have been even stronger: consumer discretionary stocks in the Russell 2000 are up 189% on average since the bottom; materials stocks rose 152%; energy shares gained 145%, financial-services stocks added 98%. Consumer discretionary has been the year's best sector so far, up almost 32%.
If you jump in now, you're not getting any bargains," said Ed Yardeni, president of Yardeni Research, an independent investment-strategy firm. "If you get in here, you've got to be willing to take a pretty nasty correction along the way and stay with it. I would be more inclined to look in midcaps and large-caps at this point."
Of course, the larger end of the market has also topped expectations. The large-cap Russell 1000 Index rose 72% since the March 2009 bottom, while the Russell Midcap Index is up 95%.
But investors haven't embraced bigger stocks. In fact, they haven't been flocking to stocks at all, but when they do they've been thinking small. That's strike two.
Small-cap stock mutual funds took in almost $12 billion over the 12 months through March 31 -- about one-third of that in the first three months of this year alone, according to research firm Strategic Insight. Their large-cap peers, in contrast, saw around $31 billion head for the exits over the same year-long period, including a $10 billion exodus in the first quarter. The trouble is that the small-cap arena's biggest gainers have been mostly higher-risk, lower-quality names -- meaning companies with little or no earnings and in weaker financial shape. That suggests a surge in speculation, not strength.
"If you want to get the most octane out of the bull market, you do it in small-caps," Yardeni said.
Small-cap stocks outperform large caps 90% of the time in the first year of a bull market, according to Standard & Poor's. As the rally progresses, this trade unwinds -- not always smoothly -- and the market takes a new direction that can persist for many years. By the bull's third birthday, small-caps do better than large-caps only about half the time.
"The high-beta stuff has worked exceptionally well," said Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch. ("Beta" measures a stock's performance compared to a benchmark index. So a higher-beta strategy will be riskier than the market as a whole.)
Eight of the Russell 2000's top 10 stocks in the first quarter were from the beaten-down consumer discretionary and financials sectors, for example, including Tuesday Morning Corp. /quotes/comstock/15*!tues/quotes/nls/tues (TUES 6.59, +0.17, +2.65%) , Pacific Capital Bancorp /quotes/comstock/15*!pcbc/quotes/nls/pcbc (PCBC 2.08, -2.03, -49.39%) , and Ruth's Hospitality Group Inc. /quotes/comstock/15*!ruth/quotes/nls/ruth (RUTH 5.86, +0.25, +4.46%) , each of which were up around 200%.
DeSanctis doesn't see these cyclical sectors doing much from here. "I don't know if they can continue the momentum," he said. "You could get a rotation into more conservative areas that will be better performers."
Small-cap returns in this rally, DeSanctis wrote in a recent research report, are "too good to be true." He is pointing investors to health care and other lagging sectors, and to high-quality companies with larger market values and solid, predictable earnings.We have started to see earnings estimates fall for the small-caps and this can suggest a change in leadership," DeSanctis noted. Over long periods, he said, companies that deliver on earnings expectations have outperformed non-earners by a wide margin.
Plenty of strategists are of the mind that the small fry can still run, not least because the second year of a bull market is typically good for small-caps.
"I disagree that small-caps are expensive," said Rich Bernstein, head of investment strategy firm Richard Bernstein Capital Management. "Small-caps are cheaper than China. For more than two years now, small-cap value in the U.S. has outperformed China. Yet there's a consensus in the United States to invest in large-cap multinationals that are exposed to emerging markets; why follow the crowd?"
That said, the crowd has favored small-caps over large-caps for the better part of a decade. The Russell 2000 gained almost 4% annually on average for the 10 years through March 31, while the Russell 1000 was basically flat and the Russell Top 50 Index of the market's largest companies lost 3% on an annualized basis.
Value-seeking buyers are already looking away from small-caps. Boston-based institutional investment manager GMO forecasts that actively managed U.S. small-cap portfolio returns over the next seven years will average less than 1% annually, while actively run high-quality U.S. large-cap strategies could deliver as much as 7.9% a year.
"Small-caps have led for nine out of the last 10 years," Oppenheimer's Belski said. "Prior cycle leaders are never the new cycle leaders." Strike three called.
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