Thinking Big and Looking Small

November 6, 2008  

Geoffrey Rogow and Kejal Vyas report:

Small-capitalization stocks are good bets to lead the next bull market. But any rally they experience in this bear market shouldn’t be trusted.

As typically happens during the throes of an economic recession, market veterans have begun lining up riskier small stocks, knowing these names offer the greatest potential return once the economy stabilizes.

But few investors have pressed the buy button yet. That’s because even if the economy suddenly turns around, the damage caused by the credit crisis will continue to place a premium on safety until the market has fully repaired itself.

“As we get really comfortably wrapped around the blanket of defensiveness, investors will continue to pull away from riskier plays, but if you look out 12 months or so, larger companies don’t look like leadership stocks,” said Satya Dev Pradhuman, research analyst for Cirrus Research and author of “Small-Cap Dynamics: Insights, Analysis, and Models.”

Usually considered more economically sensitive, small-cap stocks have historically been seen as good indicators of where stocks overall are headed. Tuesday, for example, while large caps rallied more than 3%, the smaller names closed up a little more than 1%. Financial stocks in the S&P 500 jumped 5.7% while the S&P SmallCap 600 financial sector was up a mere 1.6%. The subdued response indicated continued concerns over the state of the economy and suggested that near-term gains for large caps are probably unsustainable.

Small-caps have been underwhelming of late.

In his book, Mr. Pradhuman notes sharp gains in the early 1990s for the Russell 2000, which jumped 58.6% from the bottom of the cycle in October 1990 through the following year and more than doubled before the next market downturn. Similarly, the 1970s were marked by a superior return from small caps, which produced a 19.4% annualized gain, as opposed to the 8.5% return from blue-chips issues over the same time period.

Strategists and traders say the banking system is at the heart of why investors shouldn’t buy and hold small caps just yet. Banking loan spreads have to return to more normal levels for smaller companies to recover. Unlike the strong balance sheets of global conglomerates, newer companies don’t have the same consistent revenue streams of bigger names. Moreover, banks are more likely to write a loan for a company such as General Electric Co. than for a company still trying to move into a niche marketplace.

On top of a more stabilized market, as heightened volatility and small-cap underperformance typically coincide, Mr. Pradhuman said small-stock investors would be more likely to buy once the government’s banking measures gain momentum, while he would also need to see the fixed-income market settle.

Traders should be prepared to take advantage of what will likely be a few dead-cat bounces in the sector. Notably, in June, small caps surged to the tune of 14% from lows in late January, with some on Wall Street pointing to that move as a sign that the market was ready to rally. Obviously, that wasn’t the case as October has crushed all stocks, but particularly small caps. While the benchmark Russell is now up 17.7% from its five-year low hit Oct. 27, the index is still off 18.8% since the beginning of October.

“There have been false starts, as in May and June when Libor spreads broke and we thought maybe this was it, but for the real thing we’d need months of stability and recovery,” Mr. Pradhuman said.

Despite all the economic reasons not to believe in a small-cap stock rally just yet, there also is a fundamental one: hedge funds. Lori Calvasina, head small-cap and mid-cap equity strategist for Citigroup, said hedge funds have deeper stakes in small companies because of their long-term potential. With more redemption requests expected well into 2009, hedge funds will have to keep even larger portions of their portfolios in cash.

“For small caps to outperform, it’s contingent on hedge-fund money coming back to the market,” said Ms. Calvasina.

Longer term, small caps still have the best upside potential, especially in the early parts of an economic recovery. They were the leadership groups of the late 1970s and early 1980s even while the economy was under pressure, led at first by energy names and then by technology. And when the next wave emerges, Steven DeSanctis, head small-cap strategist for Merrill Lynch, said history points to health care and technology for the small names to own, with both sectors jumping more than 65% in the first year after the last two bear markets.

Mr. DeSanctis said both sectors tend to be more volatile and are likely to ramp up with the economy. Furthermore, companies in the sectors are trading at levels below where they were when coming out of bear markets in the past, indicating that an upswing could be even more drastic.