Stocks & Markets December 20, 2009, 7:08PM EST

Small Cap Stocks: Searching for the Stars of 2010

While small-cap stocks may not match their 2009 gains, investing pros tell Bloomberg BusinessWeek where they see opportunity in this category

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Rich valuations and investor concerns about the economic impact of the Federal Reserve's anticipated withdrawal of some of the massive liquidity it pumped into a crisis-ridden financial system suggest that small-cap stocks won't perform as well as larger ones in the year ahead.

The small fry have had a pretty good year in 2009, if you go by two widely followed proxies: the Russell 2000 index, which gained 22.3% through Dec. 18 after declining 34.8% in 2008, and the Standard & Poor's SmallCap 600-stock index, which rose 20.8% after dropping 32% in the preceding year. (The large-cap Standard & Poor's index of 500 stocks was up 22.1%, following a 38.5% decline.)

The Federal Reserve's policy committee said on Dec. 16 that it will shut down currency swap lines with foreign central banks by Feb. 1. It also plans to wind down most of its special domestic liquidity programs on that date, wrapping the others up a few months later.

The Fed made no mention of a rising inflation risk. The central bank said it expects to keep interest rates near zero for "an extended period," likely through the first six months of 2010. For such investment professionals as Barry Knapp, head of U.S. portfolio strategy at Barclays Capital, the Fed will have no choice but to raise rates at least a little if the economy seems to be growing more rapidly than anticipated.

"The Fed policy dynamic will take over at the end of January," predicts Knapp, who sees gross domestic product growing by about 3.5% in 2010.

Momentum play: Load up on small caps

For investors inclined to time their small-cap exposure within business cycles and who insist on trying to predict the future, a period of restrictive monetary policy is when they should slightly reduce, but not eliminate, holdings in the category, says Gregg Fisher, president and chief investment officer at Gerstein Fisher & Associates in New York.

Based on his belief in momentum investing, Fisher thinks the next three to six months might be a good time to hold more, rather than fewer, small caps in your portfolio.

Bank of America's small-cap research team expects large caps to outperform small caps in the new year, mainly because of more attractive valuations for large caps and weak fundamentals for small caps. In the third quarter, small caps' earnings dropped 28% on a greater-than-15% decline in revenue, while sales and profits for large caps fell much less, according to a Dec. 11 research note. Fundamentals have improved across the market-cap spectrum over the past few quarters and this will remain true for the fourth quarter. When this occurs, small caps usually lag larger cap stocks, the note said.

Barbara Walchli, who manages the multi-cap Aquila Rocky Mountain Equity Fund (ROCYX), foresees slower economic growth over the next 10 years, but she isn't so sure smaller companies will underperform larger ones in 2010. The common perception is that bigger companies will do better next year due to their being more exposed to international markets, which are expected to recover faster than the U.S. economy, while smaller companies are more tied to the domestic economy.