Small-cap stock run could herald broader recovery

NEW YORK — Even as Wall Street skids lower almost by the day, and the major indexes have touched the levels of a bear market, some analysts are actually finding some signs in the performance of small-company stocks that might be pointing to the early stages of a much broader recovery.

Small-cap stocks are now doing better than the overall market — and that has some analysts hopeful. These stocks typically get knocked lower during tough economic times as investors look to safer investments, but historically are the first to rise when the economy rebounds.

(enlarge photo) Specialist Thomas Facchine, center, directs trading at his post on the floor of the New York Stock Exchange, Thursday July 3, 2008. Stocks fluctuated in volatile trading Thursday after a private research group reported that the nation's services sector contracted last month and as investors absorbed a mostly tame report on employment. (AP Photo/Richard Drew)

In the year following the end of each of the past 10 recessions, small stocks rose an average of 28 percent compared to 19 percent for large stocks, according to T. Rowe Price. And, the Russell 2000 index of smaller companies has performed significantly better than larger-company indexes so far this year.

While the Dow Jones industrials are down about 15 percent for the first half of the year, the Russell 2000 has fallen 10 percent. And, since the lows of mid-March, the Russell has risen almost 7 percent compared to the less than 1 percent gain by the broader Standard & Poor's 500 index.

"The classic thinking is that if you're going to bet on a recovery, small-caps are going to lead the charge," said John Thornton, co-portfolio manager of Houston-based Stephens Investment Management Group. "And when all you hear about is oil prices, interest rates and credit exposure, in the small-cap world you can find unique companies that can grow despite a bad economy."

An official recession hasn't been declared because it takes several quarters for economists to analyze all the data. And, in many cases the U.S. was already on its way out of a recession by the time economists got around to calling one.

The general feeling on Wall Street is that the U.S. is already in a recession, and one that likely began at the end of last year. So, that means the rise in small-cap stocks might indicate the recovery is already under way.

To be sure, that doesn't mean its entirely safe to rush back into the market and snap up undervalued blue chip stocks. Thornton points out there are still a number of variables — like the global credit crisis and soaring oil prices — that makes the current market cycle hard to predict.

The upside right now of small-cap indexes like the Russell 2000 is that they're largely shielded from credit market turmoil. Instead of big global financial brands like Citigroup Inc. or Merrill Lynch & Co., the small-cap indexes contain regional banks with little or no exposure to mortgage-backed securities and other risky investments.

Kim Caughey, equity research analyst for Fort Pitt Capital, said she thinks the rise of small-caps might be more of an anomaly and not some kind of sign of a rebound. Still, she said many investors who aren't buying small-caps, and who gravitate toward the well-known large-cap names, should be more willing to diversify into smaller companies.

"Investors should be less market cap sensitive and more value sensitive," she said. "We love stocks of all sizes, and if I see good value I'm allowed to go out and buy it."

While small-caps are known for being volatile, they are also the asset class that has the best potential for fast growth. The fact that small-caps are often in niche industries helps them to withstand even a bad economy.

There is evidence that rising inflation might even be an advantage for small companies over their larger counterparts. Smaller companies typically have leaner staffs and more cost controls, so that helps them better manage high commodities prices.

In addition, the products they make or services they delivered are often specialized enough where they can defray some of the higher costs to customers.

"We might not know if the rise in small-caps portends a larger rebound," Caughey said. "But, there's no reason not to move into these stocks as a whole, especially if you're looking for growth."

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