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Behind the Surge in Small Cap Stocks

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Small companies have been on a tear this year, but strategists warn the party may be over.

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Their market caps might be puny, but there's been nothing small at all about their headline-making moves this year. Since January 1, small-cap stocks have racked up double-digit gains, easily besting their larger rivals.

Year-to-date, the S&P SmallCap 600 is up 10.6%, with nine out of 10 sectors in the black. (Telecom is down 8.8%).

In contrast, the S&P 500 is up 5.3%, with three sectors in the red: Energy, Telecom, and Utilities.

The iShares S&P SmallCap 600 Index (IJR), which includes holdings like Skyworks Solutions (SWKS), Mednax (MD), Gardner Denver (GDI), and Varian Semiconductor (VSEA), is up 10.67% YTD and it's up 67.07% in the past 52 weeks.

The iShares Russell 2000 Index (IWM), which includes holdings like Human Genome Sciences (HGSI), UAL (UAUA), Tupperware Brands (TUP), and 3Com (COMS), is up 10.06% YTD; up 65.35% in the past year.

So, why all the enthusiasm for small-cap companies?

"Economic projections look better," says Sam Stovall, chief investment strategist at S&P Equity Research. "Now, if the economy improves, and if lending loosens up, then those denied the lending -- the small companies -- are likely to benefit the most."

Stovall adds, "Investors are also looking at momentum. They want to see what is working and that is where they are putting their money. They are looking to get back to breaking even more quickly."

Analysts forecast that earnings at small companies will surge 122% this year, far outpacing large-cap and mid-cap firms, which are expected to see earnings increases of 37% and 53%, respectively.

Some might conclude that's the green-light to pile in, right?

Not so fast, says Stovall.

"You might think that is great and you want to jump on small-caps," he tells us. "But they are already getting bid up in anticipation of good earnings results."

Fact is, those pint-sized companies look rich right now: The S&P SmallCap 600 is trading at 21.4 times 2010 estimated results while the S&P 500 is trading at 15 times 2010 estimated results.

"Valuations look high, in my opinion," says Stovall.

Should we expect the outperformance of small caps to continue, looking ahead?

Stovall says he's concerned that we're getting close to a point in which the stock market might experience a significant digestion of gains here.

That's a nice way of saying: expect a sell-off.

"Trees don't grow to the sky and stocks don't rise forever," he says. "I do believe we will probably be higher 12 months from now, but every bull market does go through its digestive phases."

Small-caps, during such a pullback, would get banged up more than large-caps.

"A correction [a decline of 5% or more] is inevitable," Stovall says. "In the past 60 years, we have had a median of one decline of 5% or more in the second year of a bull market."

Stovall adds, "When we do see a decline, it is the higher beta, as well as those asset classes and sectors that appreciated the most during the rally, that then decline the most during that give-back."

We also checked in with Jeffrey Kleintop of LPL Financial, who tells us he has now lowered his small-cap exposure.

Kleintop thinks the pace of economic improvement will moderate looking ahead, which is typically when small-cap performance starts to wane.

"Usually, we see that about a year into the recovery," he tells Minyanville. "Their performance becomes more in-line with large-cap peers."
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No positions in stocks mentioned.
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