Small May No Longer Be Beautiful

While most investors ignored US small caps, preferring to play with bonds and emerging markets, the sector more than doubled. Now they’ve finally begun to tumble. Is this just a seasonal correction, or are larger market shifts at work? MoneyShow.com editor-at-large Howard R. Gold explains further.

In today’s markets, size really matters.

Until recently, small-capitalization stocks (those with market values between $300 million and $2 billion) were tearing up the charts.

From the bear-market lows of March 2009 through the end of 2010, the Russell 2000 Growth index had soared over 130%, far outpacing Russell’s index of large growth stocks. They continued their strong performance through April, when the Russell 2000 hit an all-time record close of 865.29.

But despite this huge advance, small-cap US growth stocks attracted little interest from investors. Individuals were busy selling US stocks, while buying bonds and funneling their equity money into emerging markets—even though their returns lagged those of US small caps.

Call it the stealth rally, which I noted early in January; it may turn out to be the giant small-cap bull market that came and went while no one noticed.

This month, small caps have gotten walloped: The Russell 2000 has lost 5.1% so far in May, trailing its large-cap counterpart by at least two percentage points.

That weak performance has come as the so-called “risk-on” trade has unwound. Institutional and individual investors have sold stocks, gold, silver, oil—any asset perceived to have benefited from the Federal Reserve’s “quantitative easing” (QE2) policy, which winds up in June.

While investors have thrown speculative assets overboard, the beleaguered US dollar has rallied off its recent lows, reversing recent trends.

So, it’s no surprise that larger, defensive stocks have been setting the pace—led by, of all things, health care. Health care stocks, longtime market laggards, are off to their best start since 1998, topping all sectors so far this year, according to The Wall Street Journal.

And the big money is moving in that direction.

“Hedge funds…are starting to show a preference for blue-chip, large-cap stocks, which tend to fare better in moderating growth, after rotating heavily into small caps late last year and earlier this year,” the Financial Times wrote.

“The push into large-caps comes as speculators have gone long on the [S&P] 500 for the first time since the beginning of the year, according to futures positioning data compiled by analysts at [Société Générale]. Short positions against the Russell 2000 are at their highest since September,” the newspaper reported.

This month, according to the FT, health care, consumer staples, and utilities have all chalked up strong gains, while previous pacesetters energy, financials, and materials have been in the red.

So, is this temporary, or has the market made a significant mid-cycle shift away from high-flying small caps and into larger, steadier growers?

Louis Navellier thinks much of the move is seasonal. The well-known manager of small and large growth stocks stresses that both have terrific earnings momentum, the key metric he tracks.

But, as he told me, “Small caps are better between November and April,” and do worse during the summer months, when the market as a whole tends to underperform.

“You’re still in the insecure summer months. In May we got hit by the ‘sell in May and go away’ crowd,” he said.

The mood among investors is pretty gloomy, he acknowledged. “I’m out there talking to brokers. They’re scared to death,” he said. “I sell more corporate bonds or defensive stocks [than any kind of growth stock].”

NEXT: Why Bigger Is Better Now

In fact, Navellier likes “very conservative, defensive blue chips” like Reynolds American (RAI), Altria Group (MO), and Brazilian electrical utility CPFL Energia (CPL), in addition to classic growth stories like Apple (AAPL) and VMWare (VMW). (Disclosure: I do not own any of these stocks.)

When a high-octane growth guy like Navellier recommends stodgy utilities and tobacco companies, you know something’s changed.

Navellier is looking for “a big correction this summer”—particularly in August or September. But, he added, “I’m very, very positive. If you talk to me in November, I’ll be buying small caps like crazy.”

I hope he’s right...but it’s also possible the market cycle has turned.

We’ve had two years of stock market rallies amid a weak recovery. Although manufacturing is coming back strongly, emerging markets are slowing as their central bankers clamp down on inflation. That should reduce consumer demand in those countries.

Meanwhile, the higher prices of food and fuel will keep a lid on consumer growth in the developed countries as well.

Here in the US, real estate shows no sign of a rebound, and the housing market is struggling to find a bottom. As Kelly Evans of The Journal put it: “Housing is the economic cycle.”

The lack of a housing recovery already has reduced the early cyclical bounce we’ve seen in recoveries past. In fact, Russell Investments expects the current recovery’s peak to occur in August, a “cyclical peak [that] would be the lowest in the 45-year sample period.”

And with QE2 about to fade, the Fed is removing a huge source of liquidity from the market.

Meanwhile, we’re just finishing off the best three quarters of the four-year presidential cycle. The S&P has gained more than 25% from its late August 2010 lows.

And if you look at this chart on Fidelity Investments’ Web site, we appear to be moving out of the mid-cycle phase of the economic recovery.

True, the Fed hasn’t started tightening yet—a hallmark of that stage historically—but that will likely take longer this time because of the distortions from the financial crisis and deep recession. Meanwhile, leadership already has shifted from mid-cycle stalwarts like technology and energy to late-phase bellwethers health care and consumer staples.

Does this mean that we won’t have an extended bull market of the kind that Laszlo Birinyi and Jim Paulsen are looking for? No. Nor does it mean that small caps won’t make a huge comeback later this year, as Louis Navellier expects.

But my guess is we’ve probably seen the big, early-cycle advance in small caps already, and we should begin gradually shifting equity holdings to larger companies, mostly on the growth side. As I wrote last week, it’s a good time to protect the profits you made in the two-year bull by taking some of your money off the table.

And if you do that, you might want to start small.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. You can follow him on Twitter @howardrgold and read more commentary and watch his videos on his Web site, www.howardrgold.com. Visit his new political blog, www.independentagenda.com.