Dec. 18 (Bloomberg) -- Japan may be a harbinger of what lies ahead for stock markets worldwide.

Investors there are turning away from shares of smaller companies in favor of larger ones such as Suzuki Motor Corp. and Canon Inc. as a slowing economy weighs on the overall market.

In the U.S. and Europe, small-capitalization companies, which as a group have a median market value of about $650 million, are on a path to beat stocks of larger companies this year. The rally outside Japan runs against predictions by investment firms such as GAM Holding AG and Goldman Sachs Group Inc. that shares of so-called large-cap companies would perform the best worldwide, reversing a six-year trend.

``Japan is the canary in the coal mine,'' said Greg Kerr, who manages $500 million, including Japanese shares, for New Star Asset Management Ltd. in London. ``I'm nervous about equity markets generally, and I think you'll see small caps lead markets on the way down.''

Japan's benchmark Nikkei 225 Stock Average, which tracks companies with a median market value of 816.4 billion yen ($6.9 billion), has risen 5 percent this year. The Topix Small Cap Index, whose 1,178 members have a median capitalization of 32 billion yen, has fallen 12 percent.

In other major markets, shares of smaller companies have outperformed. In the U.S., the Russell 2000 Index, a gauge of companies with a median value of $646 million, has rallied 18 percent this year. The Standard & Poor's 500 Index, with a median value of $13.2 billion, is up 14 percent.

The Dow Jones Stoxx Small Index in Europe has zoomed 30 percent, whereas the Stoxx Large Index has climbed 16 percent. The indexes consist of the 200 smallest and 200 largest members of the Stoxx 600 Index, whose median value is $8.5 billion.

Japanese Selloff

Investors typically turn to large-cap stocks as growth slows. The economic expansion in Japan cooled to a 0.8 percent annual rate in the quarter ended Sept. 30, less than half what the government had estimated, from 2.7 percent in the first three months of the year. The rate will slip to 2 percent next year from 2.8 percent in 2006, according the Organization for Economic Cooperation and Development.

The seeds of the selloff in Japanese small-company stocks were planted in January, when prosecutors arrested Takafumi Horie, founder of Internet-portal company Livedoor Co., on charges of securities fraud. He pleaded not guilty.

``Horie was seen as the poster boy of New Capitalism in Japan,'' said Rowan Ewart-White, who helps manage $4 billion in Japanese stocks for GAM in London. ``When he was arrested, it felt as if the rug was pulled out from under small-cap stocks.''

Stocks began dropping the next month, reflecting an increase in small-cap valuations relative to large caps, said Philip Lawlor, chief portfolio strategist at Nomura International Plc in London. The Topix Small Cap had doubled in the past two years.

Calmer Nerves

Then in May, the yen began to weaken against the dollar and the euro, prompting investors to turn to companies with overseas earnings, including large-caps such as Toyota Motor Corp. and Honda Motor Co. The weaker yen means overseas earnings are worth more when converted into the Japanese currency. Smaller companies tend to depend more on domestic demand, which has been subdued in 2006, said Lawlor.

Large companies' earnings rose roughly 18 percent in the third quarter, while those of small caps expanded only 1 percent, he said.

Small caps elsewhere around the world held onto their lead, even after a selloff in May and June as higher interest rates prompted investors to pull back from riskier investments. ``Since then, nerves have calmed down and risk appetite has recovered,'' said Lawlor.

Large-cap proponents aren't giving up.

GAM has been predicting for much of this year that small-cap stocks would begin to trail large-caps, said Ewart-White. ``But that call has been a bit too early.''

Under Way

Now it may be beginning. Since the end of April, in the U.S., the S&P 500 has risen 9.3 percent versus 4.2 percent for the Russell 2000.

``This rotation has occurred as the U.S. economy has slowed and uncertainty about the economy has increased,'' said Nicholas Sargen, chief investment officer at Cincinnati-based Fort Washington Investment Advisors, which has about $30 billion under management. The shift into larger companies' shares is typical in a period of slowing growth, he said.

Gross domestic product growth has decelerated in the U.S. to a 2.2 percent annual rate in the third quarter from 5.6 percent in the first.

``Aside from the business cycle, the reason strategists, including me, favor large caps now is that on a relative-value basis they look cheaper,'' Sargen said. Stocks in the Russell 1000 Index, a gauge of U.S. large-caps that he tracks, sell for 18.4 times earnings for the past year, compared with 37 for the Russell 2000.

Strategists at Goldman are recommending shares of larger companies for 2007, citing the prospect of a further slowdown in the U.S. economy. Goldman forecasts U.S. growth will slow to 2.1 percent next year from 3.3 percent in 2006.

To contact the reporter on this story: Michael Sesit in Paris at msesit@bloomberg.net

Last Updated: December 17, 2006 19:14 EST