Market Insider

Stocks Outlook: Small Caps Still Have Way to Go Higher

Small caps are getting pricey, but there's still opportunities to be found, says Citigroup strategist Lori Calvasina.

"I don't think the first half of the year is the time to pull out of small caps. I think there's a trade out in the second half, I don't think we're there yet," she said. (See list on page 2 of this story for small-cap stocks recommended by Citigroup.)

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Typically, small caps lead coming out of a recession.

"They tend to beat large caps and what we've also found is typically 12 months after a recession is over you also tend to see that outperformance continue. As far as where we are in the cycle you are still at a stage from the recession perspective where small caps should e leading," she said.

Calvasina said she thinks small caps are in the same type of cycle they were in at the end of the 1982/83 recession.

"What happened in that cycle is at the bottom of the recession we looked a little pricey, but not too expensive. But then late in 1983, we got the peak on corporate profits and we saw the growth rate pull in. Typically, when you see that growth rate pull in that's something that triggers a sell off in small caps."

Another trigger investors should watch for is the availability of and demand for credit. The Fed's senior loan survey this week showed that the tightening of credit by banks has stabilized but there's still no a pickup in loan demand.

"The net percent of banks tightening standards for (commercial and industrial) loans plunged again," she said. "As long as credit is getting easier in that metric, you're typically going to see small caps outperform. When spreads are tightening, small caps are doing better than large."

"I think there's still some gas left in the tank on the credit indicators. When they start to flatten out, stop improving, even though credit will be better, that's your trigger to get out," Calvasina said.

The Russell 2000 has gained 78 percent since the market's March lows, outpacing the 62 percent gain in the S&P 500. For the month of January, the Russell 2000 lost about 3.7 percent, roughly the same as the S&P.

But interestingly, Calvasina points out that the Russell has been outperforming emerging markets lately. "We looked at the Russell 2000, relative to the MSCI emerging markets and what we found in terms of relative valuation, when we looked at trailing p/e, we basically found you are extremely cheap in small caps versus emerging markets and it's about as cheap as it's been since the late 1990s," she said.

She said the MSCI index was down about 9.4 percent from its mid-January peak, while the Russell earlier this week was down only about 6 percent from the same period. "This is the second month in a row now that small caps have beaten emerging markets on the MSCI index," she said.

Citi's Small-Cap Picks

In the small cap world, it's actually been the less liquid micro caps that have outperformed. She said those stocks were down 3.3 percent in January while the small cap universe was down 3.68 percent. The Russell 200 large caps were down 3.7 percent in January.

The valuations of small cap stocks versus large caps are a little pricier than normal, she said. At the end of January, "basically relative p/e small to large was 1.12 times and the long-term average since 1978 was 1.02 times."

"We're a little bit pricey but the maximum we've ever seen this at was 1.28 time and I think that's when you start to see the

Calvasina is currently recommending an overweight on tech but the group has issues, she said in a recent interview.

"There are the 3 sectors that look expensive and represent 28 percent of the market cap" of the Russell 2000 technology group. Those sectors are semiconductors, semiconductor equipment, and computer technology, which includes hardware and peripherals.

"42 percent of the sector looks really, really cheap," she said. Those stocks include software services, internet related companies, computer services and telecom equipment. Electronics and electronic equipment are also attractive.

Calvasina is overweight tech but has had the sector on downgrade watch for the last couple of months.

"People were moving into the financials this month, which totally baffled me. We have commercial real estate hanging over some of these banks. I look at forward p/e on the financial sector and it just doesn't' look cheap. The forward p/e (price to earnings ratio) is probably 0.8 times relative to the Russell 2000, and the long term average is 0.7 times."

Citigroup's analysts have buy ratings on the following small/mid cap tech names:

CSG Systems, Akamai Technologies, Opentable, Tech Data, Adtran, EchoStar, JDS Uniphase, Ciena  and Brightpoint. They have sell ratings on Palm, ATMI, Entegris, Brooks Automation, Intersil and Amkor.

Citi's Take on Small Caps

Other small cap names recommended by Citi analysts include Office Max, Thor, Convergys, Formfactor and Leap Wireless. They also like mid caps Phillips Van Heusen, Biomarin and Lincare.