Big Bounce Leaves Small Caps Vulnerable

Includes: DIA, IWM, QQQ, SPY
by: Alan Brochstein, CFA

If you wanted a real simple strategy to beat the S&P 500 this year, there was a single decision you might have made that would have succeeded handsomely: Buy Small-Caps. As you can see below (click on all charts to enlarge), it was a bit slow to start and a bit unrewarding at mid-year, but the Russell 2000 led the S&P 500 in both rallies, leaving the iShares Russell 2000 ETF (NYSEARCA:IWM) up twice as much as the SPDR S&P 500 (NYSEARCA:SPY):

Iwm v spy 2010

For a longer term perspective, the dominance of Small-Caps is even clearer. It may have been the "lost decade" for stocks, but someone forgot to tell the Russell 2000 members:

Iwm v spy lt

As a stockpicker, I tend to focus generally on smaller companies, so I have had a lot of wind at my back. Looking at the S&P 500, 57 stocks are up 50% or greater in 2010. That's almost 12%. 3 stocks have managed to double. Good stockpickers could have done well just working with larger companies, but it was so much easier with smaller ones. In the Russell 2000, which currently has 1915 constituents, 413 names are up 50% or greater (21.6%), while 130 have doubled.

I have been a bull on Small-Caps as a sector, but the market now seems to appreciate them as an asset class after perhaps wavering during the financial crisis. I expect to continue to find attractive securities among the smaller set, but I don't expect the dominance to continue. While I remain bullish on M&A, which I believe has been a big driver late in the year favoring the smaller companies, I am cognizant that the strength of the dollar this year probably played a role in constraining Large-Caps. Most importantly, the valuation of smaller companies no longer stands out. The 2011 PE for the Russell 2000 is pushing 20X, while the S&P 500 trades at 13.3X. It wasn't that many years ago that the two traded in line. To me, the market now fully appreciates the better growth and the stronger balance sheets that the members of the R2000 demonstrate relative to those in the S&P 500.

The dominance of smaller stocks over larger ones has persisted for many years. While I am not predicting that the trend will reverse, I do believe that the 13% spread in performance for 2010 will be hard to replicate in 2011. I am bullish, expecting the S&P 500 to rise 20% or so. Even in that environment, which might normally favor the higher-beta of smaller stocks, I would expect the Russell 2000 to perform +/- 5% for the full year.

Disclosure: No stocks mentioned.

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