Commentary: Why Small Caps Will Keep Getting Trampled

If finally seeing the Dow close above 10,000 on Mar. 29 didn't mean much to you, you're in good company. Peer closely at the market, and you'll notice that vast sectors of Corporate America and the investors backing them have been sitting on the outside, looking in on this party. And the chances are, they're not being invited anytime soon.

The Dow Jones industrial average has, incredibly, doubled since November, 1995. But if you were among those who thought small-caps offered more growth potential than, say, IBM, you were out of luck. The Russell 2000 index, which tracks some of the nation's smallest companies, has risen just 32% during the Dow's climb. And it is down 9% since the beginning of 1998.

Small companies are getting crushed, unless they have ".com" in their name, of course. And big companies--that is, really big companies--are soaring. The dichotomy is breathtaking. The 100 largest companies in the Standard & Poor's 500-stock index have contributed roughly 90% of that index' 6.8% gain this year, according to Morgan Stanley Dean Witter.

ROCKY ROAD. The market's lack of breadth makes it seem like a shaky foundation for another leg of a bull market. True, many of Wall Street's top strategists, including Abby Joseph Cohen, the sage of Goldman, Sachs & Co., predict that the Standard & Poor's index of 500 stocks will rise 8% by yearend. But for investors hoping that Dow 10,000 will somehow lift the flagging fortunes of a broader array of stocks, the news is not promising. Even so, most market mavens believe small stocks will continue to suffer. "The only thing that could change this right now is a major shock to the system," says Scott Black, a small-cap specialist at Delphi Management in Boston.

What's boosting the giants? Above all, it's their ability to generate strong, sustained profit growth. Over the past five years, earnings at the nation's 30 largest companies have increased 19.5% on average, says Jeremy J. Siegel, a finance professor at the Wharton School. The comparable figure for Russell 2000 companies is less than 10%. And they've swung wildly.

This year, the earnings outlook is foggy. Analysts expect small-cap profits to be up 26% and large-cap profits to gain 17%. But large-caps should still come out ahead in the stock market. The reason? Investors trust profit forecasts for large companies more than they do for small companies. That makes sense, given the long track records of such companies. "As long as investors are making 20% returns investing in the S&P 500, they think: `Why should I bother with anything else?"' says John Ballen, chief investment officer at Massachusetts Financial Services in Boston.

The big boys are also the biggest beneficiaries of low inflation. In an economy where most companies have little pricing power, many of the top U.S. companies, such as Microsoft, Intel, Pfizer, and General Electric, have a greater ability to control costs than smaller companies--by strong-arming suppliers, for example. Similarly, large companies' high stock prices and strong profits give them enormous flexibility to acquire smaller companies and expand.

COMEUPPANCE. Small-caps have another drawback: They lack liquidity. Mutual-fund investors have pulled some $8 billion out of small-cap funds so far this year--for small stocks, no small deal in terms of selling pressure. Most issues are so thinly traded anyway that big investors can't buy large blocks without affecting the stock price. At the same time, the popularity of Net stocks is sucking away capital from otherwise attractive non-Net companies, both big and small. Stock in DelMonte Foods Co., for example, is down 22% from its February initial public offering.

History shows that small-caps will eventually get their due. After all, for seven decades, from the 1920s forward, small-cap stocks earned a 12.5% average annual return, vs. 11.2% for large caps, according to Ibbotson Associates in Chicago. Small stocks have almost always outperformed large stocks following recessions, and sometimes after major market corrections. "Clearly, history shows that the trend is going to change at some point," says Ballen. But it won't be because of Dow 10,000.

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