Small-Cap Stealth Rebound Shows Risk Appetite Still Alive

The most defensive stocks in the U.S. this week have been some of the riskiest. To Prudential Financial Inc., that bodes well for the rest of the market.

Small-caps, whose 13 percent plunge starting in March presaged losses that have erased $2 trillion from equity prices, are up 3.5 percent in three days, beating everything from high-dividend payers to makers of consumer staples. Strength in the Russell 2000 Index comes even as a measure of larger companies known as the Russell 1000 Defensive Index drops.

Advances this week in Inc. to Martha Stewart Living Omnimedia Inc. show investors are regaining confidence that should bode well for a recovery in the Standard & Poor’s 500 Index, according to Quincy Krosby, a market strategist at Prudential Financial. They’re rising after suffering some of the worst losses in the equity market this year when investors bailed on stocks with the highest valuations.

“Going into small-caps shows that investors are willing to take on risk at the right price,” Krosby said by phone from Newark, New Jersey. The firm oversees more than $1 trillion. “Small-caps serve as a barometer for the broader market. They usually run up when there’s an underpinning of domestic growth.”

The Russell 2000 rose 0.7 percent to 1,092.90 at 10:46 a.m. in New York. The measure’s 1.3 percent gain yesterday capped the biggest three-day advance since June. Broader stock measures did worse, with the S&P 500 ending little changed and the Dow Jones Industrial Average sliding for a sixth day.

Food, Utilities

At the same time, companies that investors consider havens because of their steady earnings have been falling. A measure of S&P 500 food companies, beverage makers and other consumer staples has lost 2 percent in the past three days. Utilities slipped 0.3 percent.

Data indicating that the U.S. economy is holding up even as overseas growth slows is a good sign for small-cap stocks, which are usually more dependent on the local economy. Recent reports showed production at American factories rebounded last month, claims for jobless benefits fell to a 14-year low and households held the most optimistic views in two years.

“U.S. fundamentals still appear to be pretty good,” John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees about $230 billion, said in a phone interview. “People may be looking at small-caps more favorably because of their generally larger domestic exposures.”

Volatility Indexes

Companies in the Russell 2000 get an average of 83 percent of their sales from North America, according to data compiled by Bloomberg from firms that provide such information in their financial statements. That compares with 70 percent for the S&P 500.

Small-cap stocks have a long way to go before recovering from the selloff. The Russell 2000 is still down 6.7 percent in 2014, with energy shares retreating more than 20 percent.

The Chicago Board Options Exchange Russell 2000 Volatility Index rose 2.9 percent to 26.22 yesterday. A similar measure for the S&P 500 slipped 4 percent to 25.20. On Oct. 15, the small-cap volatility measure closed below the large-cap gauge for the first time ever.

While valuations on smaller stocks are still higher than for the S&P 500, they’ve gotten cheaper. The small-cap measure trades at 18.8 times reported earnings, down from 21 in July, according to data compiled by Bloomberg. The S&P 500 has a price-to-earnings ratio of 16.8.

Early gains in small-caps shares have foreshadowed market turnarounds in the past. When stocks retreated in July, the Russell 2000’s low point happened six days before that for the S&P 500.

“Small-caps are kind of bottoming here,” Mike Balkin, manager of the $535 million William Blair SmallCap Growth Fund, said by phone from Chicago. “Some of these stocks got the air let out of them and it’s creating some great buying opportunities.”

Before it's here, it's on the Bloomberg Terminal.