Jan. 3 (Bloomberg) -- Smaller U.S. companies are rallying the most since 2003 relative to the Standard & Poor’s 500 Index, a sign to BlackRock Inc. and JPMorgan Funds that the economy will strengthen and spur a third year of gains for investors.
The Russell 2000 Index, comprised of stocks with a median market value of $528.5 million, rose 25 percent in 2010, beating the S&P 500 by 13 percentage points. The return left the benchmark gauge for American equity at the lowest valuation ever compared with the small-cap measure, according to data compiled by Bloomberg.
Increases in smaller companies that are more dependent on U.S. demand have preceded faster economic growth and the biggest equity rallies of the last two decades, data compiled by Bloomberg show. With the S&P 500 trading at half the price-earnings ratio of the Russell 2000, larger companies are too cheap to pass up, BlackRock’s Kevin Rendino said.
“It’s good news that small companies are doing well,” said Rendino, a money manager at the New York-based firm that oversees $3.45 trillion. “If small companies are doing well, it tells you that the U.S. economy is getting healthier, and that bodes well for the market.”
The S&P 500’s book value, a measure of corporate assets minus liabilities, shows larger stocks are the cheapest on record relative to smaller companies. The S&P 500 was valued at 2.22 times net assets, compared with 2.04 for the Russell 2000 on Dec. 27, the narrowest gap in data tracked by Bloomberg since 1995. The average spread over that period was 1.1 points, the data show.
On the basis of profit, shares of larger companies are half as expensive as smaller stocks. The S&P 500 trades for 15.8 times reported income, while the Russell 2000’s multiple is 34.4. The median ratios for the indexes since 1995 are 19 and 29.9, respectively, data compiled by Bloomberg show.
Earnings at smaller firms are a better indicator of economic strength than larger businesses because they get a greater proportion of their sales at home, according to Rendino. The median company in the Russell 2000 takes in all of its revenue from North America, compared with 75 percent in the S&P 500, financial reports compiled by Bloomberg show.
Profits among smaller companies rose five times faster than larger ones last year, and analysts’ predictions show the outperformance will continue. The average company in the Russell 2000 posted a 165 percent gain in income last year, the most since 2003, as S&P 500 profits rose 29 percent, according to data compiled by Bloomberg. More than 19,000 analyst forecasts for 2011 show earnings for the small-cap stock gauge will rise 80 percent, compared with 22 percent for the measure of large-cap stocks.
The last time the annual gain for the Russell 2000 was this much higher was in 2003. That was first year of a bull market in which the S&P 500 doubled through 2007, data compiled by Bloomberg show.
“The message that the small-cap rally has been giving is that the economy is recovering,” said David Kelly, who helps oversee $445 billion as chief market strategist for JPMorgan Funds in New York. “Large caps look cheaper than small caps, and people, if they are long-term investors, should be a little overweight large caps.”
Exxon Mobil Corp., the world’s largest oil producer, rose 7.2 percent last year. That trailed the 33 percent rally among energy companies in the Russell 2000, led by a 365 percent surge in Houston-based Magnum Hunter Resources Corp. and a 295 percent advance for Callon Petroleum Co. in Natchez, Mississippi.
Valuations for both large and small companies are too high, according to Rob Arnott, who helps oversee $61 billion at Research Affiliates LLC in Newport Beach, California. The S&P 500 slipped 0.2 percent on Dec. 30 after its price-earnings ratio reached a six-month high even as reports showed jobless claims fell and businesses expanded the most in two decades.
“I’m not bullish,” said Arnott, the firm’s founder. “We have an economic recovery that’s built on the foundation of stimulus. The economic recovery is very fragile.”
The S&P 500 has increased 23 percent since July 2 amid speculation policy makers would take steps to spur faster U.S. growth. The Federal Reserve expanded its record stimulus program on Nov. 3, saying it plans to buy up to $600 billion of Treasuries to stimulate inflation.
Lower GDP Forecast
Economists cut their 2011 forecast for U.S. gross domestic product growth to 2.4 percent in October from 3.1 percent in May, according to estimates compiled by Bloomberg. They have since raised their projection to 2.6 percent. Growth slowed to a rate of 2.6 percent in the three months ended in September, down from 5 percent in the fourth quarter of 2009, according to the Commerce Department in Washington.
Large companies tend to lag behind smaller ones in the first two years of bull markets and beat them during the following 12 months, according to data compiled by Sam Stovall, chief investment strategist at S&P. Since 1949, the S&P 500 had an average gain of 5 percent in the third year of equity rallies, more than double the advance of small companies, he wrote in a Dec. 6 report. The S&P 500 has surged 86 percent since the bull market began in March 2009, while the Russell 2000 has risen 128 percent.
The S&P 500 gained 0.1 percent to 1,257.64 last week, completing the biggest December rally since 1991. The Russell 2000 retreated for the first time in seven weeks, falling 0.7 percent to 783.65. The S&P 500 rose 1.1 percent to 1,271.87 at 4 p.m. in New York today, while the Russell 2000 climbed 1.9 percent to 798.56.
First-time claims for unemployment insurance decreased to 388,000 in the week ended Dec. 25, compared with the median economist forecast of 415,000 in a Bloomberg News survey, the Labor Department said. The Institute for Supply Management-Chicago Inc.’s gauge of business conditions rose to 68.6 in December, exceeding the most optimistic forecast in a Bloomberg News survey and the highest level since July 1988.
“The economy seems to be recovering nicely again, and the soft patch is over,” said Barton Biggs, managing partner of New York-based Traxis Partners LP, which oversees $1.4 billion. “I’m betting the next move in the S&P 500 is up, not down.”
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