This was supposed to be the year of the large-cap stock. The weak dollar and booming global economy were set to propel export-driven revenue at large-cap companies, while a weak U.S. economy in the throes of a wholesale financial quagmire spelled trouble for small caps with their mostly domestic focus.   


Oh well, so much for prognostications. The S&P 500 index of large-cap stocks was down 13.7% year-to-date as of September 8 while there was only a 2.5% drop in the small-cap S&P 600 index. (As befitting it's middle-child status, the S&P 400 midcap index placed between the two with a loss of 7.5%.)

Similarly, by September 8 the small-cap Russell 2000 index had declined by only 4.3% year to date while the Russell 1000 index of large-cap stocks fell 13.6%. But small caps really shined this summer. Between the July 15 market dip (after the Bush administration rescued Fannie Mae and Freddie Mac the first time) to September 8 (when the markets surged after Fannie and Freddie were rescued a second time), the Russell 2000 gained 8.8%, besting a 3.8% uptick for the Russell 1000.

So, what happened? "I must admit I'm somewhat puzzled," says Preston Athey, portfolio manager at the T. Rowe Price Small-Cap Value fund. "Small caps on a valuation basis aren't particularly cheap, so there's nothing to say they should outperform."
Athey suggests one possible reason: A looming recession in Europe and an overall global economic slowdown are crimping the export story that favored large caps. "But there are plenty of small-cap companies who export or sell components to exporters," he says.

Christian Anderson, an associate portfolio manager at Russell Investments, says some of the small-cap outperformance is due to how two of this year's headline sectors--energy and financials--are structured within the large-cap and small-cap indexes. The energy component of the Russell 1000 is heavy on integrated oil companies and refiners that have done poorly in 2008, as well as money center banks such as Citigroup and Bank of America that have been crushed.

Meanwhile, the Russell 2000 has a bigger energy weight in drillers, equipment services and coal companies that have sparkled until recently, as well as in smaller regional banks that have declined less than the money center banks. Anderson says the Russell 2000 also has a bigger weighting in real estate investment trusts, which had held up relatively well in 2008.

Granted, small-cap results on the whole look good only on a relative basis. But it's enough to make tea leaf readers speculate whether the performance is signaling a bear-market turnaround-if not the end of a possible recession.

History As A Guide
Traditionally, there's a strong interplay between downturns and small-cap performance. Merrill Lynch found that small-cap stocks experienced median declines of 29% in the 18 bear markets since the 1930s, versus 21.4% for large-cap stocks. But in the 12 months following these bear markets, small caps delivered average median gains of 41.4% while large caps made gains of 32.4%.

The investment advisor Ned Davis Research found that during the 10 recessions since the 1940s, small caps have lagged large caps by 3.6% going into a recession. But small caps outperformed by 8% in the six months after a recession's end and 12.6% after 12 months.

Tim Hayes, chief investment strategist at Ned Davis, believes we're probably in a recession right now and that the small-cap run is possibly the first sign that the economy will start to turn better next year. In May, he reallocated his portfolio weightings from large caps into midcaps, but he's not ready to rush into small caps because the sector generally underperforms during market declines and he doesn't think we're out of the woods yet.

"There are two things I want to see happen first," Hayes says. The first is more evidence that the market has bottomed. The second is narrowing credit spreads that signal a healthier financial system and more liquidity, which is key for smaller companies.

He says the combination of tight credit and the small-cap run-up during the summer "suggests that small-cap performance is overdone a bit and is vulnerable to another pullback."

Throw in uncertainty associated with the upcoming presidential election, and Hayes believes that late-2008 could be a better entry point for small caps.

Jim Bruyette, a managing director and certified financial planner at Harris SBSB, believes the recent small-cap rally is an aberration. "They've been between 8% to 15% overvalued relative to large-cap stocks for a couple of years," he says. "On paper, this should be a climate where this type of small-cap performance reverses."

Despite the dollar's recent strengthening, Bruyette says most of the good news on the earnings front is coming from exporters, and this typically favors larger companies. And the ongoing credit crunch--which he believes has another nine to 12 months to unwind-should be a significant headwind for small caps.

Bruyette also points to reports that some of the summer surge in small-cap stocks was due to heavy short covering by hedge funds for their bearish positions on Russell 2000 stocks. "If short covering is a large a factor, as it appears, it just strengthens our conviction to underweight small caps," he says.

The Case For Small Caps
Mary Lisanti, portfolio manager of the Adams Harkness Small-Cap Growth fund, believes that talk of a slowing global economy favors small-cap companies and their domestic focus. And as the U.S. economy recovers, she says the place to be is in companies that can accelerate earnings. "That puts small caps in an interesting light," she says.

Among Lisanti's top holdings is Buffalo Wild Wings, a casual eatery chain with a sports bar motif she says is grabbing customers from the likes of Applebee's and Chili's. "They've done a good job improving operations and have exceeded expectations," she says, adding that it's growing at a rate of about 25% and has no debt. As of early September, its shares roughly doubled from their March lows.

Another of Lisanti's big holdings is Cavium, a maker of semiconductors used in networking equipment. "If companies keep spending on networks they will use Cavium," she says. "It's a really interesting company if you have a 12- to 18-month view because they have a lot of leverage coming into 2009 and it's cheap based on '09 earnings." As of early September, Cavium shares traded at 21 times 2009 earnings that were forecast to grow 68%. Its share price was slashed in half from last autumn's 52-week high.

Irene Hoover, portfolio manager of the Forward Small-Cap Equity fund, says there are always opportunities in the vast small-cap space among companies with dominant positions in niche industries. One of her favorite sectors involves green technologies, particularly suppliers of sophisticated products that have pricing power.  One recent holdings was Clean Harbors, a provider of environmental services that's the nation's largest hazardous waste disposal company. She also has a big stake in domestic natural gas producers. "We like natural gas companies with technologies that can exploit shale and coal-bed methane opportunities," Hoover says. Her recent top ten holdings included energy plays Bill Barrett Corp., Petrohawk Energy, Hercules Offshore and Comstock Resources.

The Case For Other Caps
When it comes to sizing up the investment landscape by market capitalization, S&P chief equity strategist Sam Stovall favors the midcap space. For starters, he expects better earnings growth at midcap companies. The operating earnings growth forecast in 2008 for companies on the S&P 400 midcap index is 10%, with an average price-to-earnings multiple of 17. Operating earnings on the S&P 500 are expected to sink 3% this year, at an average multiple of nearly 16; on the S&P 600 small-cap index, earnings are predicted to be flat while the average p/e multiple is more than 20. As a result, he says valuations are better for midcaps than both large and small caps.

Stovall also likes midcap stocks for another reason. "My feeling is that if money managers are going to engage in style drift, large-cap investors are probably more inclined to drift down to midcap, and small-cap investors are likely to go up into midcaps," he says. "In a sense, midcaps benefit from a bit of cheating on either side."

Based on 2009 consensus analyst estimates, S&P expects all three indexes to experience substantial operating earnings growth next year, led by the S&P 500 (that is, if one believes in consensus estimates).

T. Rowe Price's Athey says he's been buying technology, health care and financial companies. He actively sold a lot of his energy positions during the sector's huge rally in the first half of the year, but has since put the kibosh on selling because he has a long-term bullish view on the sector.

Athey's fund was up nearly 1% as of early September, but evidently he's not entirely on the small-cap bandwagon. "Given that it's difficult to make the argument that small caps should be overweight based on valuation, it's just one more good argument for diversification," he says. "If I have extra money to put into a diversified portfolio, I'd think large caps and large-cap growth are among the attractive areas."