Foreign Small Caps Much More Potent than Foreign Large Caps

Brazil's economic secretary sees expansion in his country's GDP of 4% to 5% by year-end. Lloyds of London sees stocks breaking technical resistance levels in Germany and the U.K. Meanwhile, government reports have shown acceleration of growth in mainland China.

As the U.S. continues its debate about the timing, durability and strength of its homegrown revival, there seems to be a lot less doubt with respect to the international scene. In fact, one sign that investors believe that economic resilience has found a foothold in emerging and developed international markets is small company outperformance.

Throughout stock market history, small caps are known for leading the way when a country's economic advancement is in its earliest stages. Three popular reasons include:

1. Small company stocks carry more risk, but have the potential for more reward. When investors feel better about economic prospects, they tend to take more risks.
2. Small companies are more likely to be focused on the local economy than larger multinationals. When a domestic economy is seen as improving near the beginning of an expansion, investors see greater earnings potential out of focused, local providers of goods and services.
3. Most large companies can withstand recessions... it's the smaller fries that often can't get the loans, venture capital or customers to survive. In contrast, when small companies manage themselves effectively in downturns, the faith investors have in proven winners surges. In fact, this is how many small companies demonstrate rapid earnings growth on the way to becoming mid-to-larger sized entities.

The U.S. benchmark for small-caps, the Russell 2000 Index, is only marginally outperforming its older brother, the S&P 500. Many seem to be saying that the worst may be behind us, but what's really in store in the future? Anemic growth? Stagflation? Double-dip recession? Or a true, red-white-and-blue recovery?

In contrast, foreign small caps are resoundingly outhustling the larger cap stock ETFs. For instance, iShares MSCI EAFE Small Cap (SCZ) is brutalizing iShares MSCI EAFE Index (EFA).

The emerging powerhouses like China and Brazil are showing very similar patterns. Take a look at how the Claymore China Small Cap Fund (HAO) has pounded its chief rival, the China 25 Index (FXI). Similarly, Market Vectors Brazil Small Cap (BRF) has gained significant ground over its larger relative, iShares MSCI Brazil (EWZ).

The early pattern of small-cap dominance does not necessarily suggest that one should abandon diversification. In fact, even overweighting small-caps in one's portfolio may result in more risk than is appropriate. (Indeed, if the global recovery turns out to be weaker than speculators are calling for today, the "relative safer-going" of larger companies may become more critical.)

However, it's clear that the world's investors believe that an economic renaissance is in the making. At least they see it for most of the world, with the possible exception of the United States.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[tc1]

Thank you for this, Gary. Your thesis about emerging small-caps is persuasive and it's very useful that you've given us some specific ETF outperformers to play on this thesis: HAO, SCZ, BRF.

I assume you still see LOTS of upside on these small-cap ETFs for the coming months/year(s).

2009 Jul 21 12:44 PM

[sheeple123jump]

.........I personally wouldnt 'assume' Anything in these markets nowadays. I also like BRF,... but BRF looks overbought now,after its nice jump out of the starting gate. I wouldnt consider buying into it until the price corrects and holds at the 28/29 area .......but in general...I wouldnt consider the future months to be any sort of 'clear sailing' for anything, anywhere in the world.... just my opinion,stormy clouds can develop quickly upon a bad christmas economic report.
Gerald Celente, trend forecaster,predicts a market collapse with such a scenario.commencing in early 2010.

2009 Jul 21 09:27 PM

[Ricard]

Perhaps what this demonstrates is that we were grossly oversold in these securities. There have been many names in the NYSE that were similarly oversold, and they've since corrected themselves much like these foreign small caps.

However, the problem with these facts is that they're retrospective. There is no real correlation with these charts and future performance. For all we know, these stocks may have already priced in a recovery, and then some. What room is left for real growth in these stocks remains to be seen.

As there is no discussion about fundamentals here, I see the author advocating a pure momentum play. Well, momentum would have had us shorting in March, and look at what that would have earned you.

I just caught wind of this article about Baidu. I'd be very cautious in this market.
seekingalpha.com/artic...

2009 Jul 21 10:11 PM