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 capsFor 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. A closer look at the revenue data, says Walchli, shows that 54% of General Electric's (GE) business is exposed to the U.S., while quite a few small and micro-cap companies, such as Ramtron International (RMTR), have as little as 15% to 20% exposure to the domestic economy. Walchli believes the more relevant question is not which size company has an edge, but whether growth-oriented stocks will outperform value stocks next year. this month, small caps outperformedValue stocks have had a great run in 7 of the past 10 years, a time of rapid economic growth fueled mostly by rising debt levels. The next decade will probably be one of slower growth amid deleveraging, which Walchli says will favor growth stocks. At such times investors tend to look for stocks whose earnings are growing faster than the overall economy and they are often willing to pay a premium for them. Small companies with a proprietary technology in a niche market can often grow faster than big companies whose overall growth won't be affected much by an outperforming niche business unit, she says. "The small caps dogged it in October and November but they're coming back," with the Russell 2000 index up 5.4% from Nov. 30 through Dec. 18, vs. a 0.73% gain by the S&P 500 index in the same period, Walchli says. This fuels her hope about their prospects in the new year. A big disadvantage for small-caps vs. larger stocks in 2010 is that they tend to be much more heavily weighted toward the financial and consumer discretionary sectors, which aren't expected to do well in the first half of next year, says Knapp at Barclays. If there is solid economic growth data in the first quarter, then some investors such as pension funds may decide it's safer to take on additional risk with smaller stocks, he adds. The decent cyclical recovery that Knapp expects to see next year would be a net positive for small-cap stocks, but they're probably a safer bet after the Fed finishes closing down its liquidity programs and raising interest rates. While smaller companies are more exposed to U.S. consumers, Knapp is more optimistic than most about a rebound in consumer spending. As encouraging signs, he cites a higher-than-anticipated U.S. savings rate of 4.4% in November and declines in the weekly jobless claims numbers. Consumption in the service sector was unchanged in the fourth quarter of 2008 and the first quarter of 2009—the worst period of the recession—even as 334,000 service jobs were being cut each month between October 2008 and March 2009, says Knapp. But 62,000 service jobs were added in November and there's a good chance that as many as one-third of the jobs lost earlier this year could come back. "entrenched" consumer frugalityThe manufacturing sector is experiencing a longer-term decline in employment, but in the third quarter both the factory work week and factory overtime increased, Knapp adds. Bel Air Investment Advisors is staying underweight on consumer discretionary names in the separately managed accounts it oversees. The consumer's return to frugality, while expected to normalize, will remain "an entrenched outlook in the future," says Gary Flam, who manages $600 million for high-net-worth investors at the Los-Angeles-based firm. "Even if they wanted to go back to spending like they did in 2005, they can't" without wage gains, which will be nearly impossible with so much slack in the labor market. Flam is also underweighting financials because he's leery of problems with commercial real estate loans and regulatory changes that may inhibit banks' ability to grow. Small-cap followers are eyeing the credit markets carefully. Credit spreads for high-yield bonds over U.S. Treasuries have fallen from a peak above 22% a year ago to roughly 7.5%, but Bank of America's small cap strategists say they don't expect credit spreads to decline much more, which could pose problems for small caps. Although Congress is trying to strong-arm big banks, particularly former TARP recipients, to increase lending to small businesses and prospective home buyers, the availability of credit to all but the most robust and larger businesses isn't expected to improve meaningfully. "There are small-cap companies that have good balance sheets, that don't need to go to the credit markets as much as you might expect," says Adriana Posada, senior portfolio manager of the American Beacon Small Cap Value Fund (AVPAX). "So we think there's room for both large and small to do well next year. It will be a stockpicker's market." debt-free, small-cap equipment makersFor Boniface Zaino, portfolio manager of the $1.6 billion Royce Opportunity Fund (RYPNX), a company's debt level and the amount of cash on its balance sheet are key measures. Even though 2010 is expected to be a hard slog for consumer discretionary stocks, Zaino says it's possible to find good merchants with products that are attractive to certain kinds of consumers. He likes dELiA*s (DLIA), whose apparel appeals to teenage girls. The company has no debt and $50 million in cash on its balance sheet. In the tech sector, Zaino likes smaller manufacturers of capital equipment such as Brooks Automation (BRKS) and Cohu (COHU), both of which serve the semiconductor industry. Each stock trades a little above book value, has no debt, and should show dramatic upside in earnings as business improves. The Semiconductor Industry Assn. has projected a 10.2% hike in global semiconductor sales to $242.1 billion next year, an 8.4% increase, and on to $262.3 billion in 2011, following an estimated 11.6% decline in 2009. Lauren Prince, a financial advisor to business owners, high-net-worth individuals, and retired people, thinks it's always a good time to buy small-cap stocks. Small businesses are known for being innovative and helping pull the economy out of recessions, she notes. Even if they have limited access to the credit markets, they should be able to find private investors who are looking for good ideas in which to put money to work. She keeps a 4% weighting in small-cap value and a 3% weighting in small-cap growth in the average client's portfolio. She likes to use the Royce Special Equities Fund (RYSEX) for the value component and the T. Rowe Price New Horizons Fund (PRNHX) for growth. modest volatility in small capsWith small-caps starting to recoup some losses from the October-November period, Prince considers this a good time to be dollar-cost averaging into smaller stocks. Bank of America's Dec. 11 note also cited higher intraday volatility inside the Russell 2000 index than in the S&P 500 index as another reason to be wary of smaller stocks right now. But volatility overall is very low, On Dec. 18, implied volatility (popularly known as the VIX) for the S&P 600 index was 23.7, not much higher than the volatility reading of 22.2 for the S&P 500 index. The fact that there's no incremental implied volatility in small caps vs. very large caps "signifies a level of complacency which is endemic in the current system right now," says Nicholas Colas, chief market strategist at BNY ConvergEx. "One thing that small and large caps have in common now is that people are awaiting fourth-quarter earnings" and expecting to see growth for both revenue and profitability for the first time in over a year, he says. "The market is discounting the full upside of fourth-quarter earnings." In order for the market to move higher in the first quarter, companies not only would need to meet their sales and profit forecasts but also start providing guidance again for future earnings, he says.
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