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Smaller Stocks May Be First Victims of Fed Pullback

When the Federal Reserve ends its easing program in June, small and mid-cap stocks—which have gained the most so far—could be the most susceptible to a pullback.

An Indian stock broker looks worried as he watches the screen in Mumbai, India.
Sajjad Hussain | Getty Images
An Indian stock broker looks worried as he watches the screen in Mumbai, India.

While market gains have been broad-based since the central bank started buying Treasurys and other debt to boost liquidity, companies with capitalization of below $10 billion have been especially powerful.

The benchmark Russell 2000 has roared more than 37 percent since the second leg of what is commonly known as quantitative easing was launched unofficially in late August 2010. By comparison, the Standard & Poor's 500gained about 28 percent during that time.

But with QE2 coming to a close with the last of the $600 billion sales at the end of next month and the market entering a historically weak time for gains, it is the smaller stocks that are being viewed as most prone to a slowdown.

Frothy valuations, increased volatility and doubts over whether Fed Chairman Ben Bernanke will greenlight another round of easingweigh as the principal concerns.

"Though Bernanke's speech at the end of April seemed to quell some fears about when interest rates will move up, we still sense that investors are worried about what happens when QE2 comes to an end," Credit Suisse analyst Lori Calvasina wrote in a note to clients.

"The timing of QE2's exit is far from ideal from a historical perspective as it is likely to hit at a time of year when small cap stocks traditionally encounter headwinds."

To be sure, the expected direction of the marketfor the entirety of 2011 is higher, and small- and mid-caps aren't projected to lose value.

But Calvasina thinks a market pullback of 10 percent or more along the way is likely, and it will be the large-cap stocks that will fare better in such a climate.

"Some of the indicators that we track continue to send signals that the best days of the recovery in small cap stock prices are likely behind us," she wrote.

The general strategy to combat the drop is either to short non-large caps or to shift allocations to sectors that will perform better. Those moves likely will pertain until the Fed shifts policy towards a normalization in interest rates, which are in negative territory compared to inflation.

"Elevated small cap valuations and higher relative volatility should be important performance factors when the Fed begins to remove accommodation," Barclays Capital analysts said in a research note. "These dynamics could create a nice opportunity for an outright short and following normalization, a relative short against large caps."

Barclays sees higher volatility ahead for the marketsafter a 2011 that has seen traditional fear measures at low levels, a climate that favors small-caps. As volatility has risen recently, larger stocks have gotten stronger, with the Dow Jones industrials the best-performing index in April.

At Credit Suisse, the firm recently has downgraded energy and tech and upgraded consumer discretionary.

Calvasina also pointed out that within the space, larger firms have done better than smaller.

"Bigger has generally been better in 2011, a dramatic reversal from 2010 trends when tinier, so called 'low quality' small caps drove the Russell 2000's strong performance," she wrote.

Also, the view towards smaller stocks is not universal.

Bank of America Merrill Lynch technical research analyst Mary Ann Bartels sees "leadership intact" with small caps over their large counterparts.

"The relative trends favor mid caps then small caps as leadership vs. large caps," she wrote in a note to clients. "The S&P 500 large cap index and the (Morgan Stanley) Multinational Index are still lagging badly.

But worries persist that until the economy gathers more steam, smaller stocks will lag.

"Small cap relative volatility remains elevated...and the combination of both high relative valuations and volatility could set up a post normalization short," Barclays said. "Moreover, while we expect volatility to continue its decline as the economy reaches the self-sustaining stage...following normalization we expect weak relative performance of small caps to persist well into the business cycle."