Small-Stock Rally Looks Like It Has Staying Power

The U.S. stock market is sounding like a broken record. And owners of small-stock mutual funds have to like this sound a lot.

Day after day for the past couple of weeks, broad indexes of small-company stocks have continued to hit record highs even as the blue-chip Dow industrials have largely struggled.

Since Aug. 1, the Russell 2,000 index of smaller stocks, perhaps the purest and broadest small-share index, has risen 5.7%, while the Dow has fallen 4.2%.

That has left the Russell index up 20.7% year-to-date, compared with the Dow’s 21.8% gain. At this pace, it won’t take long for the Russell to pass the Dow--which would be a momentous event indeed for small stocks, given their poor performance relative to blue chips since 1994.

What is perhaps most remarkable about the resurgence of small stocks (which make up the majority of shares in the U.S. market, after all) is that it has been so steady since April, and so lacking of the speculative fervor that usually accompanies sustained rallies in this market sector.

Unlike in May, 1996--the last time small stocks had Wall Street’s collective attention--there have been few instances of obscure Nasdaq-traded issues zooming from $10 to $100 in a matter of days, courtesy of fast-money “momentum” investors.

“I don’t wake up and see stocks up $4 to $5 a day, day after day,” says Jim Miles, co-manager of the $30-million Hotchkis & Wiley Small Cap stock fund in Los Angeles. “It’s more like, a $7 stock rises 3/4 one day, is down 1/4 the next, then up 1/2 the next, and so on.”

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What that steady advance suggests, first of all, is that the investors doing the buying are shopping carefully and buying slowly, so as not to tempt potential sellers of the stocks to suddenly demand sharply higher prices.

That style of buying is typically employed by only the most thoughtful and serious institutional investors. If it is indeed that group that is prospecting in smaller stocks now, there is more reason to expect this rally to last.

Plenty of money has already been made, of course. Consider:

* The average small-stock mutual fund tracked by Lipper Analytical Services in New York has risen in eight of the last nine weeks, and has beaten the blue-chip Standard & Poor’s 500 index fund category in seven of those weeks.

* Demand for smaller stocks has been quite broad. Micro-cap stock funds, which buy the smallest of small stocks, have led the way. On average, micro-cap funds have beaten the small-stock fund average in seven of the last nine weeks.

Yet even in the micro-cap sector, which is particularly vulnerable to wild swings and intense speculation because the stocks are so thinly traded, some fund managers say the nature of the advance suggests investors truly are doing their homework.

John Bogle Jr., manager of the $130-million ni Micro Cap fund in Cambridge, Mass., focuses specifically on very small companies that already boast strong profit growth. His fund is up 36% so far this year, versus the S&P; 500 index’s 26% gain. The rebound in his type of small stock, Bogle says, “Tells me that this [advance] is broad-based and is occurring in companies with real products.”

Many small-stock fans say the rebound is long overdue. Indeed, one of the strongest arguments for a continuing rally in small shares is that Wall Street’s torrid love affair with blue-chip stocks since 1994 lifted them to absurd prices relative to earnings by this summer, while thousands of small stocks sat there, ignored, unloved, and growing ever more undervalued relative to their earnings.

Now, some important trends are running in small stocks’ favor. First, many smaller firms’ earnings are rising briskly with the healthy U.S. economy. Second, the cut in the federal capital gains tax should fuel more demand for gains-generating smaller stocks over dividend-paying bigger stocks.

But perhaps most important, the recent earnings-growth hiccups for blue-chip stars such as Gillette and Coca-Cola is forcing many investors to question the still-high prices of those stocks.

“That was the wind that we needed to have shift,” says Jeff Petherick, co-manager of the Loomis & Sayles Small Cap stock fund in Boston.

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Smaller the Better

The persistent rally in small-stock mutual funds in recent weeks has been led by so-called micro-cap funds, which buy the smallest of small-company stocks. Weekly total returns of the average small-cap fund and the average micro-cap fund:

Sept.

Small cap: +2.2%

Micro cap: +2.3%

Source: Lipper Analytical Services