Is the Turnaround in Small Stocks Here at Last?

Small stocks, long the laggards of this bull market, staged a major comeback in the second quarter, whipping big blue-chip stocks for the first time since the third quarter of 1997.

In the three months ended June 30, the Russell 2,000 index of small stocks outpaced the benchmark Standard & Poor’s 500 index of blue-chip stocks by more than 8 percentage points.

“It’s wonderful,” says Chuck Royce, manager of the small-stock Royce Total Return fund. “If you could stop the clock and turn this quarter into a whole year, I’d be in heaven.”

The question is, is this the extended small-stock rebound that some Wall Street strategists have been predicting for nearly six years now? “The jury is still out,” says Laura Allen, manager of the John Hancock Special Equities fund.

Those who believe that small stocks’ resurgence will continue got some good news last week when the Federal Reserve bumped short-term interest rates only a quarter of a percentage point--and then shifted to a “neutral” stance on raising rates further.

“If there’s only one increase, I think that would tend to favor small caps,” argues Varilyn Schock, manager of the Westcore Small-Cap Opportunity fund.

Her reasoning? A single rate hike had already been priced into stocks and so won’t disrupt a market that is currently favoring smaller stocks--commonly defined as shares of companies with a market capitalization (stock price times shares outstanding) of less than $1 billion.

On the other hand, analysts who are skeptical about small stocks’ chances note that the sector lost momentum, relative to big stocks, as the second quarter wore on.

In April, the Russell 2,000 index surged 9%. In May, small stocks gained ground but only modestly so, with the Russell index up 1.4%. And in June, while the Russell rose 4.3%, blue chip stocks did even better.

“This is not like 1991-92, when small stocks were significantly beating blue chips” consistently, notes Satya Pradhuman, small-stock analyst for Merrill Lynch.

If small stocks go back to their disappointing ways, it wouldn’t be the first time.

“There’s been a fair number of false starts” in the small-stock sector in recent years, notes Robert Kern, manager of the Fremont U.S. Micro-Cap fund.

In fact, in nine of the 22 quarters since the end of 1993--the last full year in which small stocks outperformed blue chips--small stocks have actually beaten or matched the S&P; 500. They just haven’t managed to put those quarters together.

That has led to a 5 1/2-year stretch where the S&P; 500 has outpaced the Russell 2,000, on a cumulative basis, 230% to 77%.

“We have to first see a sustainability of returns,” says Allen. “Not just one quarter, but several quarters.”

That means the current quarter may prove to be pivotal in determining whether small stocks can regain market leadership before the next millennium.

Does it really matter whether small stocks beat big stocks? It does to the majority of U.S. companies, because most of them are smaller firms, not blue chips.

A sustained rally would make it easier for many smaller firms to raise money via stock offerings.

It also matters to investors who have patiently kept significant sums in small-stock mutual funds.

Finally, some experts say a small-stock rally is needed to correct a gross state of undervaluation in the market overall. “There are still tons of companies [whose shares are] selling for 10 or 12 times earnings and whose earnings are growing 20% a year or more,” says Gerald Perritt, manager of the Perritt Micro Cap Opportunity fund and editor of the Mutual Fund Letter in Largo, Fla.

In that sense, “the rally really hasn’t started yet,” he says.

What may be standing in the way of a small-stock revival? Here are some key issues:

* The higher cost of capital. Long-term bond yields have eased since the Fed’s interest rate announcement, but the yield on the benchmark 30-year U.S. Treasury bond is still up nearly a full percentage point since Jan. 1.

Rising interest rates tend to be bad for the equity markets, in part because they raise companies’ borrowing costs. That can be particularly harmful for smaller companies that are rapidly expanding, says Merrill Lynch’s Pradhuman.

“Small-cap cycles have much more to do with capital than economic sensitivity,” argues Pradhuman. “If the relative cost of capital is low, the hurdle rate for expanding is much more favorable.”

Pradhuman points out that one of the reasons smaller stocks did so well in the first three years of the decade is that the Fed slashed interest rates in 1990 and ’91 to jump-start the economy after the Gulf War recession.

That, in turn, erased the spread between banks’ prime lending rate and 10-year Treasury notes--a key indicator of the cost of business capital, according to Pradhuman.

This time around, the opposite is true. On Wednesday, the Fed moved to hike short-term rates a quarter-point--at a time when the spread between 10-year Treasuries and prime was already about 2 percentage points.

Still, Schock and other fund managers say this rate hike--because it was small and anticipated--won’t have a deleterious effect on the small-stock rally.

* Earnings growth. Over the next 12 months, small-company earnings are expected to grow faster than those of large companies, on average, assuming the U.S. economy continues to expand.

But that might not be the case in the short term. And depending on how the markets react to any short-term disappointment, “this is neutral to slightly negative news for small caps,” says Allen.

Second-quarter earnings for the Russell 2,000 companies are expected to rise 9.9% on a year-over-year basis, according to Steven DeSanctis, small-stock analyst for Prudential Securities in New York.

By comparison, large-company earnings are expected to jump 15.2%, in part on the renewed health of some Asian economies.

Interestingly, however, the situation a year ago was reversed: Smaller stocks were expected to do better than big stocks because the latters’ earnings were being hurt by the Asian crisis.

It didn’t work out that way. Big stocks far outperformed smaller stocks in the second half of 1998 because investors favored safety overall--meaning big, liquid stocks--and shunned riskier smaller stocks.

In the current environment, if risk-taking in general is on the rise, smaller stocks could continue to shine even if big companies’ profit growth is momentarily better.

* Economic growth. Historically, small-cap stocks have excelled as the economy emerges from recession--in the early-1980s and early-1990s, for example.

Today the environment is much different: It’s late in an economic expansion.

“Here we’re at a point where the Fed is raising rates to cause a white-hot economy to keep from overheating,” says Allen. And that may not bode well for this small-cap rally, if history is any guide.

* Y2K worries. The Year-2000 computer bug remains a big question mark--not just whether there will be widespread computer problems, but whether investors will begin to fear such problems, and run for cover in the second half.

“You might well see a flight to quality . . . just as we saw last year,” says Pradhuman. That would not favor smaller stocks.

* Disappointing mutual fund inflows. Despite the rally in small stocks, individual investors continue to be wary of investing in small-stock funds.

From January through May, redemptions from small-stock funds just about matched new purchases, according to the Investment Company Institute, the fund industry’s chief trade group.

The trend appeared to hold in June, according to research firm Trimtabs.com.

That makes it difficult for fund managers to become a force in the rally. “Let’s face it, managers need money to buy stocks,” says Allen.

Michael Fasciano, manager of the small-cap Fasciano Fund, agrees “there’s still a general disenchantment with small-company stocks and funds. “

But he regards this as a bullish sign: “There’s still a whole lot of money out there waiting to return to small caps. By and large, investors aren’t yet convinced that the small-cap rally is for real. But when [that money] returns, it’s going to return in a significant way.”

Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.

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