Small Caps Show Signs of Life in March

Wall Street has been very skeptical of small stocks since the last half of 2007, as the economy began cooling off. Most stock strategists are recommending that investors put their money into larger, high-growth businesses because of the economic uncertainty.

But March was a good month for small stocks. They beat midsize and large companies, and turned in some of their best daily performances in the past 21 years. Meanwhile, small-cap value stocks are returning more to shareholders so far this year than pricier small growth stocks, which are supposed to get a premium when growth is scarce. What's going on?

A look at history suggests that, actually, these results aren't wholly out of line with past slowdowns. In addition, the Federal Reserve's moves to boost market liquidity by continuing its easy-money policy could be playing a role. "There's been a bit of a temporary bailout party," says Eric Cinnamond, portfolio manager of the Intrepid Small Cap fund (ICMAX). "But there are still cost pressures and overly high earnings expectations that need to come down."

So far this year, small-cap stocks overall aren't performing as well as large stocks. The small-cap benchmark Russell 2000 index is down 18% from its last peak in July. The large-cap S&P 500 is off 14% from a peak in October.

In March, however, small stocks showed some spark. The Russell 2000 had two of its best days since 1987 last month, points out Steven DeSanctis, the small-cap strategist for Merrill Lynch. On March 18, the benchmark made its largest positive points move in more than two decades, gaining about 31 points, according to a research note DeSanctis issued on April 3. That was the same, much-awaited day that the Federal Reserve lowered its target for the federal-funds rate by 75 basis points to 2.25%.

On March 11, the small-cap benchmark turned in its third-highest gain since 1987, moving up 29.8 points, according to DeSanctis. That coincided with the Fed's announcement that it was expanding its lending to securities dealers.

Those two days also saw some of the Russell 2000's best percentage moves, with the index up nearly 5% on both days.

For the whole month of March, small stocks gained less than 1%. Large stocks, as measured by the Russell 1000, fell by about 1%. While it may be tempting to view this as a sign that the Fed's efforts are spurring a small-stock rally, "it's still a bit early to get on the small-cap bandwagon," DeSanctis said in his research note. "There are a number of hurdles that the market will face including the upcoming [earnings] reporting season and we think expectations need to be adjusted lower."

From another lens, the recent spike in small-cap performance isn't a sign of resilience but volatility. Big rallies typically occur for small stocks during bearish markets, according to DeSanctis, with stocks often falling again after posting jumps. "The volatility is breathtaking and typically spells trouble for performance," DeSanctis said in the note.

Lori Calvasina, Citigroup's small-cap and midcap equity strategist, also says earnings expectations and volatility are still a problem for small stocks. By her measure, Wall Street is expecting earnings for companies in the Russell 2000 to increase 35% this year on expectations that the second half of the year will bring recovery. Small stocks usually perform better than large ones in the final months of a recession, Calvasina says, but she's reluctant to call a bottom just yet. "We remain worried that volatility will continue to climb," Calvasina said in a research note on April 1.

As to value stocks, the group has been "the clear outperformer year to date, surprising many investors," Calvasina said. Still, this is following a pattern in past slowdowns: Small-cap value stocks have beat small growth stocks in the early phases of the past four recessions, when the rest of the markets were falling, according to Calvasina.

The bottom line?

"The peculiarity of recessions is that we never know we're in one until after the fact," says Nancy Prial, portfolio manager of the Essex Small- and Micro-cap fund (MBRSX). "The market right now is trying very hard to discount the end of this current recession, or slowdown, and has anticipated the end a few times already. But we think it's been premature."