(Dow Jones) Small-company stocks have enjoyed a good run against their larger peers, but as the economy recovers from the depths of a severe recession, past market returns suggest their winning streak may be near its end.
Small-company stocks, with more fragile business models and more tenuous access to financing, tend to get hit the hardest when the economy sours, then snap back dramatically as confidence returns. The past two years have been no exception. After plunging more than 40% in the 12 months that ended February 2009, stocks in the Russell 2000 small-cap index surged about 64% in the next 12 months, outpacing larger stocks in the Russell 1000, the corresponding large company benchmark, by about nine percentage points.
But whether these companies will continue to set the pace for the rest of market is another question. While the evidence is sometimes mixed, history suggests it may be too late for investors to capture above-market returns by betting on smaller stocks.
A 2009 study by Russell Investments found that over four recent recessions--in 1980, 1982, 1991 and 2001-- investors could win by betting on small-cap stocks anywhere from a year before the economy hit bottom until the moment it turned around. But those who bought small caps during even early stages of growth missed out completely on market-beating returns. Economists have yet to date the bottom of the last recession, but Stephen Wood, Russell's chief market strategist, expects to place it sometime in the third quarter of 2009.
"The data suggest a lot of the juice for small-cap and small-cap value is behind us," Wood says. Still, Wood adds he'd be cautious about making bold predictions in the current market. The last recession was unusual, set off by a credit crisis rather than fluctuations between inventory and demand, and other market signals aren't what he calls "table-pounding."
As a result, Russell is advising investors to tune their portfolios to match whatever their long-term goals happen to be because opportunities that might justify deviating aren't obvious.
Milton Ezrati, Lord Abbett's senior economist, has also looked at small-company stocks, through a slightly different lens. His data, covering the past 10 recessions all the way back to 1949, shows small-cap growth or value stocks led in the first year of economic recovery nine times, with the only exception being 1953. But, he adds, there were huge variations. For instance, small-cap growth stocks led large-cap growth by 33 percentage points after the March 1980 recession, but by less than one percentage point following the October 1960 one. Moreover, when Ezrati expanded the periods to three years from the end of a recession, small-cap stocks' lead frequently shrank or disappeared altogether, suggesting investors that didn't buy early were less likely to benefit.
Much like the Russell, Ezrati suggests investors can win by betting on small-cap stocks when economy is at a trough--the trick is calling the trough.
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