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By Murray Coleman

Small-cap stocks are born to run during market rebounds.

And they've been doing just that since mid-March. While analysts aren't ready to call the resurgence of small-caps a trend yet, if nothing else, it marks a reversal from the first quarter and last year.

"The conundrum we're facing today is whether this is a growth phase or just a short-term spurt," said Jerry Slusiewicz, a portfolio manager at Pacific Financial Planners. "Everyone's so focused on inflation and possible recession. But the market's recent reaction flies in the face of economic trends."

So far in the second quarter, the Russell 2000 index is up some 2% compared with the Russell 1000 index. In the past three months (starting just before a bailout of Bear Stearns eased concerns over a global credit crisis), the iShares Russell 2000 Index (NYSE Arca: IWM) has jumped 11.5%. By comparison, the large-cap SPDRs (AMEX: SPY) exchange-traded fund's up 3.6% in that same period.

But at least one pattern remains from 2007. After value outperformed growth across all cap sizes in the first quarter, in the past two-plus months, growth has come back. The Vanguard Small Cap Growth ETF (AMEX: VBK) has gained 13.8% since early March. That compares with a 9.8% increase by the iShares S&P SmallCap 600 Value Index (NYSE: IJS).

Dead Heat?

The recent moves up by small-cap growth ETFs haven't been enough to overtake their growth rivals for the entire year. Still, funds tracking the major broadly diversified small-cap growth indexes have had enough of a run to make it a much closer race.

In fact, in the case of the competing S&P style benchmarks, it's an almost dead heat now: IJS is up 1.7% vs. the iShares S&P SmallCap 600 Growth Index (NYSE: IJT) at 1.4% in 2008.

What happens in the style battle will likely be tied to a continued improvement in financials. If they can avoid another prolonged downturn, small-cap value ETFs figure to make more ground. And that's especially true when taking market-capitalization sizes into account. Consider that in the first quarter, the Russell 1000 index's large-cap financials wound up losing nearly 14%. At the same time, the Russell 2000's financial names fell just 7.2%.

"It's fair to see the recovery in small-caps as reflective of a stronger market appetite to take on risk, particularly any types of sectors tied to credit markets," said Christian Anderson, a portfolio manager for Russell Investments' U.S. small-cap funds.

Leadership is also flip-flopping in sectors. For example, the second-quarter's best performer in the Russell 3000 index is tech. Last quarter, it was the worst. One of the few parts of the market showing any sort of consistency on the year, says Anderson, is energy. (The Russell 3000 index represents a total stock market benchmark).

"We haven't seen a complete reversal in leadership among sectors," he said. "But there has been a general trend towards more cyclical and growth-oriented sectors. The more defensive areas such as consumer staples, which was a leader last quarter, is now second from the bottom this quarter."

Between styles, spurts by small-cap value stocks typically run longer than their growth counterparts. In each 10-year period starting in 1958, small-cap value outperformed small-cap growth. But that simply reflects value's long-time dominance over growth - across all cap sizes - more than anything.

So is the market setting up for another whiplash? Or, could it be that the bears represent a bunch of noise?

On Friday, the naysayers got some more fuel to feed their fire. Unemployment grew in May enough to make it the biggest one-month jump since 1986.

Keep in mind that a 5.5% level remains historically on the low side. Another contrarian viewpoint is that while the credit crisis is by no means resolved, companies aren't completely cut off from raising capital. And fears that world markets would be brought down by the meltdown that began with mortgages hasn't materialized to any huge extent.

Take a concentrated ETF such as the iShares S&P Global Financials Index (NYSE Arca: IXG). It has rebounded some 4.7% in the past three months. That might not seem like much, but consider it's still down more than 21% in the past 12 months.

Optimists are also pointing to November's presidential election. Despite what some pundits are saying on cable television, a victory by Barack Obama doesn't necessarily spell doom and gloom for stocks. In fact, a Journal of Finance study found that since 1927, U.S. stocks have performed better with a Democratic president than a Republican.

For those joining the Federal Reserve in putting inflation at the top of their red-flag list, a case can be made that conditions remain at least somewhat under control since wage growth remains in check.

By Definition

Then there's the little fact that the U.S. economy hasn't even hit one period of negative growth yet. First-quarter gross national product was actually revised up. Critics complain that those economic measures aren't accurate. Real GDP, they say, shows we're already in a recession.

But isn't that sort of changing definitions of what a recession really is - in midstream?

"We've entered into a state of recession in certain sectors - mainly housing and financials," Slusiewicz said. "But even the bears can't claim recessionary conditions are widespread at this point. Clearly, there are still pockets of growth in the U.S. economy."

So if you buy that the markets are right and better times are ahead, which is the best place to park your money right now?

"Small- and mid-caps are the place to be at this point," Slusiewicz said. "But we're not making any major changes at this stage in the cycle."

His core positions with small company stocks remain the MidCap SPDRs (AMEX: MDY) and the small-cap growth IJT. Slusiewicz also prefers the Rydex S&P Equal Weight ETF (AMEX: RSP) rather than the traditional market-cap-weighted SPY. "We like to spread our risks in large-caps by going with an equally weighted index," he said.

But both Anderson and Slusiewicz emphasize that while they're still cautiously optimistic, markets remain extremely cloudy.

"People need to remember that while the second quarter is shaping up as an improvement in market conditions," Anderson said, "it's a rebound out of nearly complete chaos in the first quarter."

Slusiewicz agrees. "This market's still threading the needle on stagflation," he said. "But what I'm telling my clients is that it's still too early to be overly bearish. We're sticking with our core positions."

Source: The Long Road: Bears Go Home (for Now)