Small-Cap Stocks: Is the Rally Over?

Betting on recovery fueled a big rise in small-company shares, but the recession's resurgence amid a continuing credit crunch is worrying investors

By David Bogoslaw

Score one for the small fry: Small-cap stocks have generally had a bigger bounce than large-cap names since March. But now that the initial phase of the stock market rebound appears to be over—and expectations for an economic recovery have become more muted—small caps may have a hard time achieving further gains.

One reason for concern is that smaller companies tend to have less cash on hand to finance business activities and need more access to the capital markets. But that access is likely to remain constrained until a return to general economic health is more assured. Smaller companies also tend to be more domestically oriented than larger ones. With U.S. consumers less able to tap into shrunken—if not evaporated—home equity and more inclined toward savings, reliance on that customer base is a riskier bet.

The small-cap universe, like the rest of the stock market, has seen its share of sector rotation recently. Just how much formerly out-of-favor groups may be back in investors' good graces may become apparent in the annual rebalancing of the small-cap benchmark Russell 2000 index on June 26. Financial services and health-care stocks are expected to have the largest number of additions to the index, while energy and durable-producer names are expected to lose the most members, according to a June 15 research note from Goldman Sachs.

The performance of small-cap stocks is clearly tied to many features of an economic recovery, and the fact that a recovery is developing more slowly than was the consensus a few weeks ago argues for a muted rebound in small caps—but not the total reversal of their gains to date, says Bruce McCain, chief market strategist at Key Private Bank (KEY) in Cleveland.

A bigger concern for McCain is where we are in the small-cap cycle. The last cycle began in 1999 and appeared to have run its course by late 2006. But by early 2008 small-caps had begun to outperform again, which McCain's analysis showed had more to do with the relative underperformance of large-cap financial services stocks.

How high is too high for small caps?

Small-cap names now look fairly expensive on a price-to-earnings basis compared with large-caps, which means the phase of the cycle may be more important than the fact that this recovery could prove somewhat anemic compared to past recoveries, McCain says.

Valuation is the key factor for Bill Stone, chief investment strategist at PNC Wealth Management (PNC) in Philadelphia, who is keeping a market weight of about 3% of his clients' overall portfolios in small-caps. "At a certain price, it's worth taking a risk" related to small-caps' bigger debt loads, says Stone, "but it doesn't seem to be the thing to do at the moment,"

Paul Baumbach, a wealth manager at Mallard Advisors in Newark, Del., says his outlook on the economy has been cloudy for the past six months. His concern that the recovery in small cap stocks has outpaced that of large caps so far this year, making them less attractive on a relative basis, offsets any enthusiasm he might otherwise have about them.

The fact that returns for small-cap mutual funds were roughly double those of large-cap funds—6% vs. 3%—from March through the end of May doesn't necessarily mean small-cap stocks are now relatively more expensive, says Jonathan Rahbar, a mutual fund analyst at Morningstar Funds (MORN).

"A lot of financing ended up drying up for them before it did for large-caps [as a result of the credit crisis last year], so naturally they took a harder dive," he says.

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