The Long Road: Bears Go Home (For Now)

June 06, 2008

Small-caps are reasserting their market leadership. What does that say about recessionary jitters and calls to junk your portfolio?


Small-cap stocks are born to run during market rebounds.

And they've been doing just that since mid-March. While analysts aren't ready to call the resurgence of small-caps a trend yet, if nothing else, it marks a reversal from the first quarter and last year.

"The conundrum we're facing today is whether this is a growth phase or just a short-term spurt," said Jerry Slusiewicz, a portfolio manager at Pacific Financial Planners. "Everyone's so focused on inflation and possible recession. But the market's recent reaction flies in the face of economic trends."

So far in the second quarter, the Russell 2000 index is up some 2% compared with the Russell 1000 index. In the past three months (starting just before a bailout of Bear Stearns eased concerns over a global credit crisis), the iShares Russell 2000 Index (NYSE Arca: IWM) has jumped 11.5%. By comparison, the large-cap SPDRs (AMEX: SPY) exchange-traded fund's up 3.6% in that same period.

But at least one pattern remains from 2007. After value outperformed growth across all cap sizes in the first quarter, in the past two-plus months, growth has come back. The Vanguard Small Cap Growth ETF (AMEX: VBK) has gained 13.8% since early March. That compares with a 9.8% increase by the iShares S&P SmallCap 600 Value Index (NYSE: IJS).

Dead Heat?

The recent moves up by small-cap growth ETFs haven't been enough to overtake their growth rivals for the entire year. Still, funds tracking the major broadly diversified small-cap growth indexes have had enough of a run to make it a much closer race.

In fact, in the case of the competing S&P style benchmarks, it's an almost dead heat now: IJS is up 1.7% vs. the iShares S&P SmallCap 600 Growth Index (NYSE: IJT) at 1.4% in 2008.

What happens in the style battle will likely be tied to a continued improvement in financials. If they can avoid another prolonged downturn, small-cap value ETFs figure to make more ground. And that's especially true when taking market-capitalization sizes into account. Consider that in the first quarter, the Russell 1000 index's large-cap financials wound up losing nearly 14%. At the same time, the Russell 2000's financial names fell just 7.2%.

"It's fair to see the recovery in small-caps as reflective of a stronger market appetite to take on risk, particularly any types of sectors tied to credit markets," said Christian Anderson, a portfolio manager for Russell Investments' U.S. small-cap funds.

Leadership is also flip-flopping in sectors. For example, the second-quarter's best performer in the Russell 3000 index is tech. Last quarter, it was the worst. One of the few parts of the market showing any sort of consistency on the year, says Anderson, is energy. (The Russell 3000 index represents a total stock market benchmark).

"We haven't seen a complete reversal in leadership among sectors," he said. "But there has been a general trend towards more cyclical and growth-oriented sectors. The more defensive areas such as consumer staples, which was a leader last quarter, is now second from the bottom this quarter."

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