Small-cap stocks have come roaring back during the past few months after an absolute bloodbath earlier in the year when the credit crisis caused frightened investors to flee Wall Street's riskier names. Small caps have rallied more than 16 percent from March lows and are now outpacing the Standard & Poor's 500 index for the year. As of Monday, the iShares Russell 2000 is off 2.8 percent for the year, compared with a 6.9 percent drop for the S&P.
Too bad the whole thing could be a head fake. To repeat: Markets are still nervous (See last Friday's 2 percent drop in the Dow Jones industrials after a bad jobs report), and investing in smaller companies with less-proven track records is a tough sell, especially with everything from the uncertain economy to a probable end to Fed rate cuts adding headwinds to the sector's recent climb.
Let's start with earnings. Through the first quarter, analyst estimates for small caps have come down. That's the good news. Unfortunately, those forecasts could still be too high, given broader weakness in a few sectors. According to Merrill Lynch, the Street now sees earnings growing just 3.4 percent for small caps this year. But that number includes some bubbly predictions for troubled sectors like consumer discretionary, where earnings are expected to jump 55 percent during the fourth quarter. (That projection excludes homebuilders.) That's a hefty order for one of the bits of the economy most vulnerable to slower spending.
Lingering doubts about the rest of the year don't warrant the sort of fast recovery we've seen so far, according to Steven DeSanctis, Merrill's small-cap strategist. "Obviously we still see credit issues, but the overall environment has gotten a little better. But does it justify this move off the bottom for small caps? I think no," he said. "You're making a lot of assumptions that things have gotten a lot better in a short period of time. I'm still skeptical of the economic backdrop."
There's a second unanswered question for smaller stocks: The Fed's next move. Part of the latest rally in small caps comes thanks to heavy doses of liquidity injected by the Fed to support the financial sector after the collapse of Bear Stearns. That cash, plus some added confidence, trickles down to small caps, offering an unloved sector a bit of additional support. Doug Roberts of Channel Capital Research says all the liquidity injected by the central bank will continue to help small stocks—as long the Fed doesn't shift gears and return to tightening. If the Fed moves at all this year, the outlook for small caps is risky. "If that happens, liquidity dries up and small caps get killed," Roberts says.
In the meantime, a Fed on pause helps shares of growth-oriented small caps, which have lost out to value, where weaker companies benefited from loose monetary policy and easier financing terms. Looking ahead, small-cap growth could do better, since these stocks are less likely to be forced to tap unfriendly debt markets. Also, part of the reason value-oriented small caps have risen lately is a lift from energy stocks in small-cap indexes that have rocketed along with rising oil and commodity prices.
All this doesn't mean investors should forget about the smaller names in their portfolios. While the small-cap indexes might be weighted down by the same headwinds that afflict the rest of the market, the beating already handed out has created an opportunity for select names to explode out of the gate once markets turn back to unloved smaller names. Also, remember that while small caps may be volatile, they outperform larger names historically. Channel Capital's Roberts notes between 1927 and 2007, small stocks ($250 million to $1 billion) returned 12.2 percent, compared with 9.71 for large caps.
All this creates an opportune time for active managers to load up on small companies while avoiding the problem areas that could drag small-cap indexes back below the S&P 500. Jim Oberweis, a small-cap growth manager at Oberweis Securities, admits the first half of 2008 has been brutal; he calls the first quarter "probably the toughest quarter in the last 20 years" for small-cap growth names. His strategy for the rest of the year includes a focus on big small-cap names, or firms worth about $500 million to $1.5 billion, as the best choice for investors. He especially likes technology. A couple of names he likes that fit that criteria are Anadigics (ANAD), Axsys Technologies (AXYS), Omniture (OMTR), and Mellanox (MLNX).
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