Small Stocks Are Once Again Big, but Will It Last?

Wall Street has staged a convincing--if relatively quiet--comeback from its February mini-panic. And the market's leaders once again are smaller stocks, the same sector that spearheaded the major rallies of 1991 and 1992.

The Dow Jones industrials bottomed at 3,302.19 on Feb. 18, one day after President Clinton unveiled his economic plan and two days after the Dow plunged 82 points in anticipation of that plan.

Since then, the Dow has rebounded 4.3%. Meanwhile, the American Stock Exchange market value index and NASDAQ composite index--both made up largely of smaller companies--have recovered 5.2% and 5%, respectively.

Small stocks' rebound is more significant when measured from the NASDAQ composite index's bottom, reached the week after the blue chip low: The NASDAQ index's nadir was about 650, so the rise since then is a hefty 7%.

Donald Hagan, chief sector analyst at the market research firm Ned Davis Research in Nokomis, Fla., also notes that the NASDAQ market's breadth--a measure of the number of advancing stocks each day versus the number of losers--has remained positive.

Combined with the NASDAQ index's rebound, "this says that the short-term indicators are confirming the long-term bullish trend" in smaller stocks, Hagan says.

That is important to more than a few nervous investors, of course. Because small stocks were such a hot story in 1991 and 1992, individual investors have deluged small-stock mutual funds with cash in recent months, trying to get aboard the wagon train.

Many of those NASDAQ buyers have been enticed by extraordinarily bullish projections from some market pros, who have argued that small stocks are only at the start of a multi-year rally. Trust in that trend runs high.

Richard McCabe, market analyst at Merrill Lynch & Co. in New York, is a believer in the long-term NASDAQ story.

But he is cautious about the near term, and worries that small stocks are vulnerable to a more severe selloff soon.

McCabe notes that, despite the stream of cash that has been pumped into small stocks this year, the NASDAQ composite index is up just 2.7% for the year to date. So while the rebound since February is encouraging, he says, it has barely put small-stock prices above year-end levels--even with the heavy demand from new buyers.

"The public buying is not creating any further great gains," McCabe says, and that traditionally is a warning sign of a market top. What it suggests is that institutional investors are leaving the market as the public is entering.

McCabe also worries about the excessive list of new stock issues that are attempting to come to market.

While new issues allow young companies to finance their futures, they also soak up capital that might otherwise pump up existing stocks.

On Tuesday, two hot new issues hit the NASDAQ market: Wall Data, a Redmond, Wash.-based computer-networking software maker, sold 2.88 million shares at $20 each. The stock zoomed to close at $22.75. Also, Santa Ana-based Pacific Sunwear, a casual wear retailer, sold 1.8 million shares at $13 each. By the close, the stock was trading at $15.75.

The only way to justify that kind of excitement over NASDAQ stocks--or any stocks, for that matter--is to assume that the companies' earnings growth will be stellar. Indeed, if the small-stock rally is to gain new steam in April, first-quarter earnings reports will have to look very good, many analysts argue.

On that count, some pros contend that there's good reason to be encouraged. In the third and fourth quarters of last year, many small firms saw year-over-year earnings gains of 20% or more.

This quarter? "Our contacts with a lot of small to mid-(size) companies that we own indicate there shouldn't be any material deviation from the last few quarters' trend," says Brian Berghuis, a vice president of the T. Rowe Price New Horizons small-stock mutual fund in Baltimore.

The U.S. economy entered the first quarter with powerful momentum, analysts note. And because small companies tend to be exclusively dependent on the domestic economy--rather than on overseas business--they should have an earnings advantage in this quarter over multinational firms, which are likely to be hurt by Europe's slump.

Still, some small-stock veterans fear that investors expect too much of NASDAQ companies, and that the red-hot rally that began last fall has pushed many small stocks to overpriced levels. The February setback didn't fix those overvaluations, some say.

"It just seems like expectations are too, too high," says John Rogers, who manages $2.2 billion at Ariel Capital Management in Chicago.

"The perception is that interest rates are down and there's nothing else to do with your money but put it in the stock market. But when everyone feels that way, it's usually the wrong thing to do."

Stocks' Comeback

How key market indexes have rallied since Feb. 18, when the Dow industrials reached their February low on fears about the Clinton Administration's proposed tax hikes. Year-to-date gains also are shown.

Tues. Change since: Market index close 2/18 12/31 Amex market value 423.08 +5.2% +6.0% NASDAQ composite 695.47 +5.0% +2.7% S&P; mid-cap 163.87 +4.6% +2.1% S&P; 500 451.37 +4.5% +3.6% NYSE composite 248.81 +4.5% +3.6% Dow industrials 3,442.95 +4.3% +4.3% Dow transports 1,536.63 +3.4% +6.0% Dow utilities 237.79 +2.7% +7.6%

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