Are Small-Cap Stocks Signaling a Recovery?

In times of economic uncertainty, investors don’t usually flock to volatile assets like small-company stocks. Instead, they tend to favor havens like bonds or shares of stable, industry-leading blue-chip companies.

But have you seen how small-capitalization stocks have been performing lately?

Despite all the bad news surrounding record-high oil prices, mounting job losses, and continuing troubles in housing, the Russell 2000 index of small stocks has soared 12.7 percent since mid-March. By comparison, the Standard & Poor’s 500 index of large stocks is up by a more modest 3.5 percent.

For investors, this surprising situation raises an important question: Are small stocks signaling that the worst of the economic storm is behind us?

Historically, a small-stock rally during an economic slowdown has often foreshadowed better times ahead. Ned Davis Research of Venice, Fla., studied economic downturns since the end of World War II and found that large-cap stocks tended to lose their momentum to small stocks six months after the start of an official recession. The typical recession has lasted about 10 months, so these turns often take place during the economic slump — not after one.

To be sure, no official recession has yet been declared this time around. But if, as some economists believe, a recession started in December, it wouldn’t be surprising that small stocks have begun to excel.

The recent surge in small-cap stocks “fits with many other economic and stock market indicators suggesting recovery,” said James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. He points out that not only are small stocks generally doing well, but also that the most economically sensitive sectors of the small-cap universe have performed best of late.

They include energy stocks in the S.& P. 600 small-stock index, which are up more than 40 percent since the start of April; the technology sector, up more than 9 percent; and industrial stocks, up more than 8 percent.

Bradford Evans, co-portfolio manager of the Heartland Value fund, which specializes in small stocks, says that other signs also support this optimistic view of the economy. For example, he said, “I would look to the yield curve as confirmation that the economy is possibly staging a stealth recovery.”

Last year, the yield curve — the spectrum of interest rates paid by bonds of various maturities — was inverted. In other words, a two-year Treasury note was paying out more than a 10-year note, even though the 10-year Treasury locked you into a longer commitment. Historically, this has signaled economic troubles ahead.

Today, the yield curve is sloped normally, with 10-year Treasuries paying substantially more than two-year notes. This typically signals economic growth ahead.

Still, not all market watchers are convinced that the small-cap rally is an all-clear signal for Wall Street. “I would say it’s too soon to tell,” said Samuel S. Stewart Jr., chairman of Wasatch Advisors, an asset manager based in Salt Lake City that specializes in investing in small and medium-sized companies.

Tim Hayes, chief investment strategist at Ned Davis, agrees. “I’m playing it cautiously until I can be confident in saying that the stock market has bottomed,” he said. “And we can’t say that yet.”

But even if the economic and market storm is continuing, small caps don’t necessarily have to start underperforming large-company stocks.

Small-stock earnings have held up surprisingly well during this slowdown. In the first quarter, as profits for companies in the S.& P. 500 sank 17 percent versus the same period a year earlier, earnings for the S.& P. 600 small-stock index fell less than 9 percent, according to Merrill Lynch .

And Wall Street analysts are forecasting that S.& P. 600 earnings this year will grow just as fast as large-cap stock profits — by around 8 percent, according to S.& P. “On average, earnings for the companies we own are coming through reasonably well,” Mr. Stewart said.

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Moreover, with inflation fears heightened, there is a growing sense that the Federal Reserve, which meets this week, won’t cut interest rates again.

That should be good for small stocks. Standard & Poor’s studied the performance of large and small stocks after various series of Fed rate cuts going back to 1954. On average, in the six months after the last rate cut of a series, the Russell 2000 index advanced 14.9 percent, versus just 9.4 percent for the S.& P 500.

And 12 months after the last rate cuts, the small-cap advantage persisted. Small stocks surged 25.2 percent, on average, in the year after the Fed stopped trimming rates, versus 18.9 percent for large-cap shares.

Of course, what if the biggest threat isn’t a slowdown, but inflation?

Don’t worry, Mr. Paulsen said. Historically, small stocks have typically outpaced large stocks during periods of accelerating inflation. In the 1970s, for example, as inflation was running at an average annual rate of 7.4 percent, small stocks gained 11.5 percent a year, on average, versus 5.9 percent for large stocks. Similarly, in the 1940s, when inflation was 5.4 percent, on average, small stocks doubled the performance of big stocks.

Why? Mr. Paulsen argues that just to compete, many small-cap companies must run more efficiently than industry-leading large caps. “If you’ve got companies that are operating extremely lean,” he said, “and they’re now able to raise prices, more of that increase will fall to their bottom line.”

Paul J. Lim is a senior editor at Money magazine. E-mail: .

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