After the huge runup in smaller company stocks in 2013, this year might be time for a slight retreat from these names, according to the head of small-cap strategy at Bank of America/Merrill Lynch Global Research.

Last year, smaller companies were on the same rocket ride that that lifted most stock offerings. The Russell 2000 posted a return of almost 39 percent, its best performance in a decade. But this year, stunted earnings will tell a different story, said BofA’s Steven G. DeSanctis at a Russell Investments luncheon in Midtown Manhattan Tuesday. Russell gathered a panel discussion to commemorate the 30th anniversary of its U.S. indexes.

“I tend to be the skunk at the garden party,” says DeSanctis, pointing out that he thinks small-cap stock valuations have been reason for worry after the runup in 2013, when he was generally optimistic. “For 2014, we’re looking for a modest return year, probably 5 percent to 10 percent returns for small-cap stocks. … We’ve been very nervous about valuation. Not just on an absolute basis, but relative to large caps.”

He says that forward P/E multiples in the Russell 2000 index have gone from 15 to 19 (where it now lies more than one standard deviation from the long-term average, he notes). Meanwhile, earnings have lagged at 10 percent growth. Besides that, he thinks earnings expectations are too high, and that P/E might actually be around 21.

“A lot of people are using excuses around earnings because of the weather,” DeSanctis says. “You know we’re going to see this kind of reacceleration in the second half of the year, so too should earnings.” But there are more trenchant warning signs.

He also says that as volatility picks up, it harms riskier bets —- like small caps. The VIX index has been a low 15, he said. “It’s been suppressed by QE and the Fed intervention,” he said. “As the Fed takes its foot off the accelerator, you kind of think that the VIX index and volatility are going to move higher. If you look at the Russell 2000 and the intraday swings between the high and the low, that’s starting to see a little bit of a pickup.” That’s another reason he thinks that they will lag large companies. He also pointed out that historically when valuations are in the highest quintile, as they are now, performance slips in the next 12 months.

U.S. small-cap stocks are more closely correlated with the U.S. economy, which has been performing well. He said 85 percent of the Russell 2000 stocks were up last year, so there is no longer a lot of value in the index.

In this environment, favoring large caps might be the smarter move in portfolios. He offered six themes for small-cap investors in his presentation:

1.    Favor growth over value, since rising interest rates tend to hurt value plays more. Growth plays are cheaper, he said in the presentation, and emphasizes foreign investments.

2.    To take advantage of better-performing global economies, choose global cyclicals over long-term plays.

3.    Because of volatility, he says higher-quality companies with bigger market caps should fare better than those companies with lower capitalization rates.

4.    Watch for increased M&A activity, the result of better balance sheets.

5.    DeSanctis said investors should put more emphasis on industrials and pull back a bit from consumer discretionary, which are less global and more vulnerable to rising interest rates.

6.    Because much of the value has been picked over, active managers will likely outperform, which dovetails with the “higher quality” theme as well.