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Small Stocks Double Return of Big Caps in 2010

Shares of smaller companies are on track to double the return of their bigger peers following a blowout fourth quarter fueled by increased risk-taking, takeovers and exposure to an improving domestic economy.

The iShares Russell 2000 Index ETF , the benchmark for small-caps, is up 25 percent this year, compared with just an 11 percent return for the S&P 500 SPDR , the metric for large caps and the most actively traded exchange-traded fund.

Companies such as CROCS ,Open Table , and Quicksilver have more than doubled year-to-date, fueling the gains in the small-cap benchmark. Meanwhile, the S&P 500 has been weighed down by lumbering giants with negative or measly returns like Microsoft , Walmart , Google and Pfizer .

“I do believe this trend will continue as excess liquidity and an improving economy embolden investors,” said Jim Iuorio of TJM Institutional Services. “Another explanation is that an invigorated M&A market bodes well for smaller caps as cash-rich large caps look to expand and put cash to work in a low yield environment.”

Smaller companies, considered riskier in a domestic recession marked by tightening credit, tracked the performance of their larger counterparts for most of the year, until the end of August. It was then when Federal Reserve Chairman Ben Bernanke first signaled a second round of quantative easing was likely coming.

“I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions,” said Bernanke, in a speech at the Fed’s Economic Symposium in Jackson Hole, Wyoming. The words rang the bell for investors to go out on the risk curve and buy smaller companies that would benefit most from a second dose of monetary stimulus to the U.S. economy.

The group has gotten an extra boost from recent data showing improvement in employment, manufacturing and housing. Data released Thursday showed a drop in weekly initial jobless claims, a jump in manufacturing activity in the Philadelphia area and the first gain in housing starts in three months. Meanwhile, Europe is struggling to put an end to its second debt crisis (Ireland) of the year and China is threatening to raise interest rates to curtail growth.

“Small caps will continue to outperform because the U.S. is so much stronger than the rest of the world and the S&P 500 is so much more international,” said Steve Cortes, founder of Veracruz LLC.

But it’s not just macro trends and a simple switch to risk that’s driving the gain in small caps. The companies themselves deserve some credit too for generating genuine organic growth and innovation, a concept that seems lost on most of the S&P 500 except Apple .

Longer-term return figures, where macro factors tend to cancel each other out, show that the Russell 2000 Index has trounced the broader market over a three-, five- and 10-year time period.

“Small cap growth stocks are getting credit for showing real, organic growth as opposed to government-manufactured growth,” said Michael Block, chief equities strategist at Phoenix Partners Group. “Growing retailers like Quiksilver, Deckers and Zumiez make great takeover targets as well.”

Of course, one’s favorite small caps do grow up one day. On December 9th, Standard & Poor’s announced it was adding Netflix to the S&P 500. The shares are down 2 percent since then.

For the best market insight, catch 'Fast Money' each night at 5pm ET, and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC.

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Trader disclosure: On December 17, 2010, following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders; Jon Najarian owns (MEE) call spreads; Jon Najarian owns (M) calls; Jon Najarian owns (AKS) call spreads; Jon Najarian owns (JOE) call spreads; Jon Najarian owns (C); Jon Najarian owns (CSCO); Jon Najarian owns (F), is short (F) calls; Jon Najarian owns (GS), is short (GS) calls; Jon Najarian owns (GLD) put spreads; Jon Najarian owns (NKE), is short (NKE) calls; Jon Najarian owns (ORCL), is short (ORCL) calls; Adami owns (AGU), (C), (GS), (INTC), (MSFT), (NUE), (BTY); Adami's wife works at (MRK); Finerman's firm is short (IJR); Finerman's firm is short (MDY); Finerman's firm is short (SPY); Finerman's firm is short (IWM); Finerman's firm is long S&P puts; Finerman's firm is long Russell 2000 puts; Finerman owns (AAPL); Finerman's firm owns (ARO); Finerman owns (BAC); Finerman's firm owns (BBY); Finerman owns (GOOG); Finerman's firm owns (JPM) and (JPM) leaps;’ Finerman owns (JPM); Finerman owns (MSFT); Finerman's firm owns (MSFT); Terranova owns (CRM), (VRTS), (C), (UPL), (PEP), (GS), (OXY), (NKE); Terranova owns (GLD) puts

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