Small caps were dumped with everything else on Monday, but the fact they were not as battered as bigger stocks may be a sign they will continue to outperform.
That's the view of Lori Calvasina, a Citigroup strategist who follows small- and mid-cap stocks.
"The best piece of news we got yesterday was the Russell 2000 didn't go below those July lows. I have been absolutely amazed we've stayed within this technical band this year...between 650 and 750-ish," she said.
Year-to-date, the Russell is down 13 percent, compared to 22 percent for the S&P 500. The Russell is down just 1.5 percent for the third quarter, compared to the 9 percent decline in the S&P.
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Stocks are rebounding Tuesday on hopes the House of Representatives will revisit the financial bailout bill defeated on the House floor yesterday. That vote sparked a massive selloff in stocks, which took the Dow down 7 percent; the S&P down 8.8 percent, and the Russell 2000 down 6.7 percent.
"We got down to 643 with our March low. We went to 658 in July and hit 658 Monday, and it was interesting because we hit that 658 (mid-afternoon) and then we hit it again at the close, but we never went through it," she said.
"I'm not calling a bottom. I'm watching the technicals and I think they are going to hold," she said. "My gut feeling is that the small caps are going to lead us out of this."
Calvasina says she likes small caps more than mid caps right now, because they make more of their revenues domestically than the mid cap stocks and they are relatively undervalued.
"I definitely like the small cap area a lot more than the mid cap area, because I think the international trade is going to start to unwind," she said.
The dollar was making record gains against the euro Tuesday, as investors moved into dollars on weakness in the Euro zone and news of increasing problems at European banks. A reversal in the dollar's recent strength would be a negative for small caps, she said.
Calvasina said the Russell index has been spared some of the pain felt by the S&P because it was rebalanced in June, reducing its energy exposure to just 7 percent compared to about 15 percent in the Russell mid cap index and in the S&P.
"The small cap investor has been very bearish because they're worried about credit. I think that's puzzled a lot of people," she said. "In the 1998/99 time frame, small caps started outperforming when credit was tightening," she said.
"Historically, recessions are good opportunities to get into small caps."
The credit crunch is bearing down on companies and threatens to hobble their ability to borrow. But Calvasina says the small cap companies are better positioned with cash than mid caps.
"If you look at net debt to capital for small cap and and large caps, it's 30 percent. For mid caps, it's 40 percent," she said. Large caps have 9 percent cash to market cap, but Russell 2000 companies average 15 percent cash to market cap.
"I still like some of the beaten up consumer discretionary stocks. We have credit as a huge headwind, but at least we have oil coming down. The three sectors in small cap that look very cheap are consumer discretionary, health care and tech," she said.
"From my small cap clients, I am hearing a lot of remarks like, 'At least I'm down in the small caps, and I can pick out the niche-y interesting companies that are going to continue to grow in the next 10 years,'" Calvasina said.
Citigroup recently added Dick's Sporting Goods , WebMD , Vectren and StanCorp Financial to its target list.
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