Smaller Stocks Get Left in Dust of Blue-Chip Rally

Small-company stocks are marching to a slower drummer in this year’s market rally, and some Wall Streeters are warning small-stock fans not to expect that to change soon.

One of the best proxies for smaller stocks, the Russell 2,000 index, has risen just 5.4% in price so far this year--less than half the stunning 11.5% gain of the Standard & Poor’s 500 stock index, representing the nation’s biggest companies.

The lagging performance of smaller issues also shows up in other indexes, including the Nasdaq composite of all stocks traded on that market. Despite Nasdaq’s heavy weighting of technology stocks--this year’s hottest market sector--the composite index is up 10.5% since Jan. 1, lagging the S&P; by 1 percentage point and the Dow Jones industrial average by 1.6 points.

More relevant to most individual investors is the performance of the typical small-stock mutual fund this year. Fund tracker Lipper Analytical says the average small-stock fund was up 5% through last Thursday, compared to an 8.8% average rise for growth-and-income funds that usually own bigger stocks.

What’s most disheartening about small stocks’ relative weakness is that it’s continuing a pattern that began in 1994. The Russell 2,000 index had beaten the S&P; 500 three straight years through ’93. But when the market took a hit last year as interest rates rose, small stocks fell more than big stocks. Now, despite a powerful rally in blue chips, smaller issues can’t get their motors running.

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What’s the problem? Many small-stock fund managers say investors are so focused on a handful of blue chips that they can’t see--or don’t want to see--value in the broader stock market, which is mostly made up of smaller issues. “This is a market with very narrow leadership,” says Jack Laporte, manager of the T. Rowe Price New Horizons small-stock fund in Baltimore.

But that’s not surprising, given the economic backdrop, he says. With U.S. growth slowing, large multinational companies that derive much of their sales from overseas would be expected to have better earnings potential than smaller firms totally dependent on domestic business. And with the dollar slumping, foreign earnings can provide an even bigger boost for the bottom line.

In addition, Laporte says, the blue-chip boom may be a reflection of investors’ nervousness about the bull market’s longevity: They only want to own big, easily traded stocks that they can dump in a hurry. “People are much more focused on liquidity” than in the early 90s bull surge, he says.

Fundamentally, however, small-stock pros say things are just fine with their companies. In fact, despite many investors’ apparent belief that blue-chip companies’ earnings will grow faster than small companies’ earnings this year, that’s not what analysts are expecting overall.

Claudia Mott, small-stock tracker at Prudential Securities in New York, says a breakdown of all analyst earnings estimates shows that S&P; 500 company earnings are expected to rise 15.4% on average this year, while Russell 2,000 company earnings are expected to be up 22.5% on average.

“Earnings are good across corporate America--for big companies and for small companies,” says Stu Roberts, manager of the Montgomery Small Cap stock fund in Denver. For that reason, he expects lagging small stocks to play catch-up at some point this year. Blue-chip companies like IBM and Coca-Cola get instant and extensive publicity when they report earnings, Roberts notes. “It takes a little more time for (smaller-companies’) earnings to filter down” and get noticed by investors, he says.

In the meantime, small-stock fund managers must bear watching the Dow industrials streak while their funds drag. “The neglect is frustrating,” admits Joel Tillinghast, manager of the Boston-based Fidelity Low-Priced Stock fund, up 5.7% this year.

Get used to it, warns Prudential’s Mott. Historically, she says, small-stock cycles run for several years once they start. This latest period of lagging performance only began 16 months ago. There may be good long-term value in small stocks, but once a blue-chip mania starts it can run those stocks to shocking heights (remember 1987?) at the expense of smaller issues. “The dynamics of this market just don’t lead you to small stocks today,” Mott laments.

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Blue Chip Revival

The blue-chip Standard & Poor’s 500 stock index is far outpacing the Russell 2,000 index of smaller stocks this year, after lagging for three years. Price changes each year: Year: 1995 Russell 2,000: +5.4% S&P; 500: +11.5%