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After Selloff, Small-Cap Stocks Start to Look Attractive

Small-cap stocks led the recent market downturn and they may be the place to watch for a turnaround when it comes.

The Russell 2000 fell harder than the broader market and, on Tuesday, it bounced higher. And, while it may be time to start looking for bargains again, experts don't believe the selloff is over.

AP

"It would be fair to say I'm not convinced we're there just yet, but I think things are starting to look interesting," said Lori Calvasina, Credit Suisse small and mid-cap equity strategist.

The Russell 2000 was up more than 2.1 percent Tuesday to 794, leaping ahead of the S&P 500's more than 1.2 percent gain.

Unlike the big-cap indexes, the Russell went negative for the year last week and is now up 1.3 percent year-to-date, thanks to Tuesday's rally. The S&P is up 2.4 percent for the year.

"I don't know if we're entirely out of the woods yet. The valuation data we look at hasn't totally collapsed yet. I do think we're going to be up for the year... I think we're going to be roughly 10 percent higher by year end," Calvasina said.

Before Tuesday's upswing, the Russell was off about 10 percent from its April 29 record closing high of 865.

"It held long-term support yesterday and is the strongest performer today. It's helping lead the bounce. ...I would say around 810 to 815 is going to be a big area of resistance. For the Russell, the question is, like for this whole market, is it an oversold bounce or day one of an uptrend?" said Scott Redler of T3live.com. "Or is it quadruple witching (expiration of futures and options) coming up this Friday?"

Redler said he believes the Russell still has a ways to go lower, and that the market is rising in an oversold bounce. "Bottoms don't usually come in June. They come in August or October," he said.

The Rusell 2000, which is reconstituted annually, is being revamped this year with new definitions for growth and value. The stocks within the Russell are all small cap and should have a market cap between $130 million and $2.9 billion. Therefore, some of the high-flying tech names in the index will no longer qualify and would move to the Russell 1000.

Some of those names are Riverbed Technology , Tibco Software , Ariba and Acme Packet .

Calvasina said the current sell off does not seem like the correction of last July, when the Russell lost 20 percent in 46 days.

"Let's say we get a 15 percent drop. That's 735...That's the number that's been in the back of my head. I think in small cap, the momentum can be strong one way or the other, but this is the time you want to be doing your homework," he said.

But she does say the valuations have made some small cap companies appealing again. At the end of last year when the market was moving higher, she notes hedge funds jumped into ETFs (IWM) that track the Russell, driving all companies in the index higher, even those that did not deserve high valuations.

"Especially in December when we had that money plowing into ETFs what happens when the money goes in, it makes the junk at the bottom run...When you put the ETF money in, there are liquidity issues in some of those names so if you're putting a lot of liquidity into these stocks, you're really pushing them up fast," she said.

The shares Trust Russell 2000 Index Fund was sharply higher Tuesday. "The May outflows were dismal," said Calvasina. Investors pulled $2.06 billion out of the IWM last month. For the year-to-date, the IWM has seen net outflows of $1.99 billion.

"The norm we've seen is when the market is rallying, small caps do better. When the market gets hit, the small caps are doing worse," she said.

"One thing we have really seen in the last two years or so, is it is just very, very hard to peg the bottom in small caps, and people who wait for the bottom tend to miss it," she said.

Calvasina likes the health care and utilities sectors in the small cap universe. She also recently took consumer discretionary from underweight to market weight. "What I love about that sector right now is how much everybody hates it. It reminds me of health care last year," she said.

She expects to see rotations within the consumer sector. For instance, she is eyeing restaurant stocks which were beaten down as investors favored apparel and shoe stocks.

"I think people are itching to go out and buy stuff, and they just weren't seeing the valuation opportunities," she said.

Redler still sees more selling ahead, but he also sees opportunities to buy. "If you sold correctly into the excitement, you always want to be able to buy back into a 7 to 8 percent dip," he said.

Questions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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