Small-Cap Stocks: Is the Rally Over?

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How expensive a stock's valuation is depends on an investor's time horizon, and there are still many attractive values to be had in the small-cap universe, Rahbar says. How smaller stocks perform from now through year-end is tied largely to what happens with the U.S. economy, he adds.

Rahbar believes most investors would generally benefit from limiting their exposure to small caps to 10% to 15% of their portfolio. The shorter their time horizons, however, the more he says they should scale back that exposure, given the greater volatility in those stocks, compared with better-established large- and mid-cap names.

Volatility is down for all cap sizes

Amid concerns over the riskiness of smaller stocks, it's worth noting that the implied volatility for the Standard & Poor's index of 600 stocks, which measures the smaller U.S. stocks, didn't spike higher during the sharp market selloff of June 22, says Nicholas Colas, chief market strategist for BNY ConvergEx Group. That means the options market isn't concerned about the incremental volatility of these stocks, he says.

In fact, volatility for the S&P 600 was 33.89 on June 23, not much higher than the S&P 500 volatility index (popularly known as the VIX) reading of 30.34. And the ongoing downtrend in stock volatility since November means that the options market is much less nervous about equities in general and is much more confident of a quick response by the federal government if another shoe falls in the financial crisis, he says.

How much cash a company has on its balance sheet is one of the criteria the managers of the Perkins Discovery Fund (PDFDX) consider when deciding to buy stocks. With a 27.41 return year-to-date as of June 22, the Discovery Fund ranks fourth in performance among all small-cap mutual funds so far this year, according to Morningstar.

"It's important that companies have enough cash to fulfill their business plan. There's definitely some stocks we have not bought because of that," says Daniel Perkins, who co-manages the $9 million fund. His top sectors right now: health care and information technology.

While there's lots of trepidation about small-cap stocks' greater sensitivity to overall economic conditions than large-caps, they have had higher returns than large-caps in the first year of recovery following each of the past nine recessions, according to Clifford Michaels, president of New York's Institutional Investment Advisors and president of the Financial Planners Association.

That's encouraging—except for one factor: Nobody knows when the current recession is going to end, which is "why it pays to be diversified," says Michaels. "It's more sensible to have some [small-caps] as an allocation to potentially get the most out of a recovery."

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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