As the Fed Pulls Back, Small-Cap Stocks Could Race Ahead
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The Fiscal Times
June 21, 2013

The small-cap Russell 2000 index closed at an all-time high on Tuesday, edging right up to the 1,000 mark (it closed at 999.99). Then Ben Bernanke took to the microphone Wednesday, and turmoil took hold of the markets. The small-cap index ended the day Thursday at 960.52, off about 4 percent over the course of two days.

But if the pundits are correct in their analysis of the reason for the market’s retreat – that the Federal Reserve may soon bring an end to the period of ultra-low interest rates – those smaller stocks may actually end up outperforming.

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Some selling pressure in the large-cap stocks is reasonable, especially those in defensive pockets of the market and above all in those that are big dividend plays and have served as a de facto alternative to bond investments while Treasury yields have languished at levels that are negative in real terms. The selling pressure is also logical in light of the stock market’s big gains this year. True, what the Fed will do and when it will do it remains less than explicit, but speculation of the sort we’ve seen in recent days is just what feeds big market moves.

One element isn’t a matter for speculation: Fed policymakers have made it clear from the start that interest rates would remain at their current levels unless and until the real economy was healthy enough to withstand higher interest costs. If the Fed does push forward with a plan to taper off its $85 billion monthly purchases of fixed income securities, it will be because the FOMC believes that economic growth is robust enough to cope with the blow.

“That’s when it makes sense to consider a reallocation to smaller cap stocks, which do offer a kind of beta play on the growth in the economy,” suggests Brad McMillan, chief investment officer of Commonwealth Financial Network, a private broker-dealer entity based in Waltham, Mass. His theory: Rather than chasing yield and income and defensive investments, investors will shift to hunting for growth. That, McMillan believes, will lead them in the direction of small-cap stocks such as those in the Russell 2000.

Already, there are signs that this might be happening. The iShares Russell 2000 Index Fund (IWN) is up 14.74 percent so far this year; the S&P 500 index’s gain is a slightly more modest 12.66 percent. And if you dig into earnings growth, as Greg Harrison, an analyst at Thomson Reuters, has done, you’ll see that a similar pattern emerges. In the first quarter of 2013, S&P 500 companies saw earnings increase 4.55 percent, but those of Russell 2000 stocks generated growth of 5.64 percent.

Indeed, smaller companies seem better able to produce growth in profits: the S&P Midcap 400 companies reported growth of 8.62 percent and those in the S&P Smallcap 600 announced profits jumped 8.55 percent. Harrison, who bases his calculations on analysts’ published forecasts, has published data suggesting that this gap may widen throughout 2013 and into next year. For 2013 as a whole, his estimates suggest that earnings for S&P 500 companies will climb 6.95 percent, while those at companies in the Russell 2000 will rise 22.66 percent. The gap is even more pronounced in 2014 projections: an impressive 13.2 percent increase in profitability for the S&P 500 but a 31.38 percent surge for Russell 2000 earnings.

Those who aren’t fans of small stock investing may well mutter that the group has historically faced many headwinds. Smaller companies, they gripe, can include many newer and less-established companies that have yet to develop big brand names or track records of sales; they may be overly reliant on a handful of bigger customers, too. Because their market capitalization is smaller, there is less stock available, which may mean that trading volumes and thus liquidity is lower – another concern for today’s ultra-risk averse investors.

On the other side, small stock bulls like to point to the fact that these companies are more likely to offer a play on the domestic economy and shelter from any economic weakness or storms abroad, in regions like Europe or some emerging markets that are slowing down.

At least some of those opinions may be out of date, suggests McMillan. While he still views small stocks as a play on growth, he does caution that it’s harder to find shelter from the global economy in their embrace. “Even if these companies themselves don’t sell overseas, their clients may, so there is indirect exposure.”

On the flip side, however, for the most appealing small stocks, liquidity concerns are likely to be less important than often thought. “Fund managers are doing a dance between valuation and future opportunities,” McMillan argues. “For attractive stocks, this creates a pool of potential buyers at various levels, meaning that it can limit the volatility on the downside.”

This doesn’t mean that small cap investing is easy or free of risk. If McMillan’s analysis is right and investors start chasing a way to play growth rather than defensive and yield-generating stocks, small caps will see big inflows of new capital. Inevitably, that will lead to pockets of overvaluation, meaning that investors choosing to pick out stocks for themselves rather than identify small-cap stock funds with solid track records that are still accepting new capital (an often-tricky proposition) may want to be wary and do some extra due diligence on valuation.

But even as the big dividend stocks are repriced to reflect the feeling that they may be less valuable when bond yields are rising, look for a similar repricing, on the upside, in the small cap universe.                          

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.