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What Are Small Caps Signaling?


One analyst says the recent waning of investor interest in small-cap companies reflects reduced expectations for US economic growth.

Small caps are struggling.

Year-to-date through August 20, the SmallCap 600 declined 1.7% versus a 3.9% fall for the large-cap S&P 500. Yet the performances during August have been just the opposite, strategists say, with small caps dropping more than twice as much as large caps.

(So far this month, though August 20, the Russell 2000 Index is down 6.09%.)

As we write here in the midday, the iShares S&P SmallCap 600 Index Fund (IJR), with holdings including Mednax (MD), Piedmont Natural Gas (PNY), Rock-Tenn (RKT), Skyworks Solutions (SWKS), and Varian Semiconductor Equipment (VSEA), is down 0.3%.

The SPDR S&P 500 ETF (SPY), which includes holdings like Exxon (XOM), Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Bank of America (BAC), is down 0.1%.

The recent waning of investor interest in small-cap companies -- which S&P defines as companies with market caps of $1.5 billion or less -- reflects reduced expectations for US economic growth, says S&P's Sam Stovall.

Indeed, this week, investors will zero in on the second-quarter GDP revision due out on Friday. It will probably clock in much slower than first printed. Given the wider-than-expected trade deficit in June and lower-than-assumed inventories, Goldman Sachs (GS) now forecasts growth to be revised to 1.1% from 2.4% annualized. (Hat tip: Markman Capital Insight.)

Last week, the Conference Board said that its index of leading economic indicators -- calculated from 10 components of the housing sector, labor market, stock prices, and manufacturing -- points to slower economic growth during the second half.

The LEI edged up 0.1% in July. Consensus called for the index to increase 0.2%, according to

The Federal Reserve has already clearly telegraphed a grim long-term forecast for the economy. The June 22-23 minutes of the FOMC stated: "A number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate, but they anticipated that, with appropriate monetary policy, both would rise over time to levels consistent with the Federal Reserve's objectives." (Hat tip: Yardeni Research.)

In addition, besides doubts about the economic outlook, investors are also selling out of small caps because these companies don't look cheap. Based on Friday's closing level, the S&P 500 is trading at a P/E of 13X 2010 estimates. The S&P SmallCap 600 is trading at a P/E of 19X 2010 estimated results.

"The small caps are now trading at an 82% premium to the market versus their normal 17% premium," says Stovall. "The economy in general is looking suspect so earnings expectations for small caps are likely to be under a powerful microscope."

More broadly, the question for investors is whether the falloff in small-cap outperformance is signaling the start of a new bear market.

Stovall notes that small company performance frequently hints at future performance for the large-cap benchmarks. As a result, the topping out of small-cap performance relative to large-cap results sometimes hints at an eventual decline in the larger-cap indices.

Right now, says Stovall, it's unclear whether the waning of small-cap leadership is foretelling a major decline in large-cap stocks. It could only be signaling a change in asset-class leadership, although he's quick to point out that he thinks there's a good possibility that we end up slipping into a bear market from here.

Since 1946, of the 15 times that the market has fallen by 15% or more, the S&P 500 continued to slide into bear market mode 12 times, or 80% of the time. (From April 23 through July 2, the 500 declined 16%.)

Regardless, the recent performance of small caps is consistent with Stovalls's core strategy: Stay defensive. He believes investors should stay underweight US equities and overweight cash due to heightened volatility, slowing global economic growth and increasing worries about a double dip.

BTIG's Mike O'Rourke isn't a card-carrying member of the double-dip camp, believing that the economic recovery will regain its momentum by year-end. However, the strategist tells us that he believes large-caps are still the smarter play for investors at this time.

"From my perspective, large-cap equities are the cheapest area of the market and the most attractive," says O'Rourke. "These large companies are flush with cash and trading at low multiples. That's the most conservative way to make the equity bet."

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