Small-cap run may fade

NEW YORK – Small-cap stocks have enjoyed a stellar run the past several years, a trend some analysts believe will continue in the months ahead. But mutual fund investors should consider their options carefully before chasing this asset’s sizzling performance, as there’s little doubt the cycle is starting to wane.

Last year, the Russell 2000 index of smaller companies surged 47.3 percent, versus a 28.7 percent rise in the large-cap Standard & Poor’s 500. Small caps have doubled the performance of large caps so far this year, as well; the Russell index, currently trading at all-time highs, is up 10.95 percent year-to-date, while the S&P 500 has gained 5.71 percent.

The current small-cap cycle, which began in 1998, is now in its sixth year. With the typical cycle lasting from five to seven years, many on Wall Street are skeptical about how much longer small-caps will be able to outperform large-cap stocks. But small-cap cycles have been known to last as long as 10 years, depending on market conditions. Researchers with Standard & Poors say a number of factors, including low interest rates, rising commodity prices and strong fundamentals, could help extend the current small-cap streak.

“There’s been a lot of talk lately that the small-cap cycle is coming to an end, but the rationale for that has been just the length of the cycle. We think there’s more to the story than that,” said Richard Tortoriello, an equity analyst with S&P. “When you look at valuations, earnings growth, the low cost of capital, the low interest rates and the easy access to money … plus the fact that small caps continue to outperform, we think they have further potential.”

Tortoriello and fellow analyst Massimo Santicchia reviewed all the major small-cap cycles going back to 1970, and found that in addition to valuations, the cost of capital is a key driver of small-cap performance. During the lengthy period of low interest rates, small companies have been able to obtain loans and refinance debt at very favorable rates. They found that rising commodities prices are also associated with small-cap outperformance, most likely because of their exposure to the industrials and materials sectors.

But with rates on the rise, Santicchia said, “conditions can only get worse from that point of view.” Indeed, any shock to the system – a sharp drop in the dollar or any radical event – would likely have an outsized impact on small-cap stocks.

So, while small-cap stocks may continue to do well for several more months, particularly as the market enters a seasonally strong period, most analysts agree it’s not a good time to be raising your stake. For individual investors, that means choosing securities carefully and watching for changes in market conditions that might negatively affect small-caps, such as a sharp rise in interest rates. That could be a signal that it’s time to migrate toward higher-quality large-cap stocks.

Most individual investors should maintain exposure to both large- and small-cap stocks at all times, regardless of what’s going on in the stock market. A good strategy might be to maintain a long-term asset allocation that’s consistent with market value weightings, said Jim Peterson, vice president of the Schwab Center for Investment Research. A “neutral” allocation such as this would call for about a 3-1 ratio of large caps to small caps in the equity portion of your portfolio, or roughly 30 percent in small caps.