Originally created 11/27/03

Outlook dimming for small-cap stocks



NEW YORK -- Stocks that gained the most during the downturn now look to have the most to lose as the economy gets better.

Wall Street's tiniest shares have had a stellar run over the last year, outperforming most everything else on Wall Street. But that party may be coming to an end as investors begin to feast on larger stocks with better opportunities in the year ahead.

That means anyone tempted by smaller stocks because of their recent rally should beware. Those stunning gains might be short-lived.

"This year has been one where lower-quality, low priced, high-volatility stocks outperformed companies with good balance sheets, sound business plans and favorable long-term outlooks," Byron Wien, market strategist at Morgan Stanley, wrote in a recent note to clients.

Small stocks are those with market capitalizations - stock price multiplied by number of shares outstanding - of about $300 million to as much as $2 billion. Contrast that with Wal-Mart and General Electric, which have market caps of more than $200 billion.

Investors historically have gone for these stocks at the worst of times, hoping to get in early before a recovery sets in. They like smaller companies because they can move faster than the big guys as soon as there is a hint of upturn in the economy.

To see this investing principle at work, look back at the first year of past bull markets. Large-cap stocks have historically gained about 38 percent vs. 56 percent in small shares, according to Standard & Poor's.

This year is no exception. Just consider the market's two best small-cap gauges: The Russell 2000 index is at its highest level in more than three years, and the S&P 600 index hit an all-time high earlier this month.

It also helps that many of these stocks were almost worthless when this year started, thanks to the devastating bear market that pushed many small companies out of business and left those that survived at severely reduced prices.

"Some stocks were just too cheap," said Jack Caffrey, an equity strategist at J.P. Morgan's private bank. "Many of these stocks were priced like they were going to be liquidated, but these companies then ended up not going away."

But the idea building on Wall Street is that this winning streak for small-caps won't last. In fact, at a Morgan Stanley conference this month for portfolio managers, those surveyed expected large stocks to outperform small shares next year by a 2-to-1 ratio.

Again, the economy will likely play a large part in this shift. The staggering 8.2 percent annual growth rate seen in the third quarter is raising hopes that the economy has finally pulled out of its rut and that growth will stabilize in the year ahead.

When that happens, investors have historically shifted out of small stocks and into their larger rivals. S&P data finds that during a rallying market's second year, large stocks jump on average 14 percent, while small shares gain only 5 percent.

That's because an improving economy often means interest rates will soon start to rise. And since small companies depend heavily on banks to borrow money, they could be harder hit than large companies. In addition, any small company that thrived with low rates - such as those largely tied to the mortgage business - could be particularly hurt.

Smaller firms also often do most of their business domestically, so they don't get the same benefits as larger companies from an rebounding global economy or the weak dollar.

And a pullback may just be due because small-caps have had such a strong run.

"Investors must believe that most of the market's excesses are in small- and mid-cap stocks and that large caps will catch up if the market does well at all in 2004," Wien said, referring to his firm's survey.

Even with all that working against small-cap shares, S&P chief investment strategist Sam Stovall points out that 2004 earnings estimates are coming in surprisingly strong for smaller companies, and are even forecast to top their larger counterparts. Expectations are for large-cap earnings to rise 14 percent vs. 24 percent for small-cap shares, according to S&P.

So maybe it's not time to write off that small-share rally just yet.