Analysts say small-caps are poised for recovery
Here are the catalysts that could bring it about
Second in a two-part special report (see part one)
By Michael Brush
moneydaily.com
In a market where a lot of fund managers don't want to mess with any
stocks they can't exit quickly in case there is a market crisis,
small-cap stocks are suffering. In fact, because of their relative
illiquidity, small-caps are at their lowest valuation levels since 1990.
Does that mean they are a bargain right now? "I think it is worth noting
that these valuation levels have always been followed by a strong rally
for the group," says L. Keith Mullins, a small-cap stock analyst with
Salomon Smith Barney.
"The stocks are cheap, they've got earnings power, which is going to be
of increasing value, and the sentiment is low. Historically, when these
three conditions exist, there is strong performance. The problem is
identifying the catalyst."
No one knows, of course, if or when small-cap stocks will rebound. But
Mullins and other strategists say you can expect any of the following
events to serve as the needed catalyst to bring them back.
* Worries about a Fed rate hike ease. Small-cap stocks typically lag
when the markets think the Fed might raise interest rates. Once the
economic data start to show that a Fed hike is not around the corner,
money should flow back into the less liquid stocks, says Mullins.
* Big-cap earnings decline. Analysts have already cut their earnings
estimates for the big-cap stocks to the low single digits for the first
half of the year. Yet expectations for the second half still remain in
double digits. As estimates are slashed for the latter half of the year
-- which is likely -- the superior earnings growth of the small-cap
stocks will start to look a lot more attractive.
"What we really need is for the big stocks to get their butts kicked,"
says Louis Navellier, of Navellier & Associates, which runs some small-
and mid-cap funds. "But we don't want them to be massacred. Because if
they go down too much, we will get murdered."
Mullins points out that last year about this time, S&P 500 companies'
earnings growth slowed down and investors became less worried about the
Fed raising rates. These two events helped small-cap stocks take off --
because they made investors more willing to take on less liquid stocks.
* Worries about Asia decline. When doubts are circulating about the
health of the world financial system, this increases the "liquidity
premium," or how much more investors are willing to pay for securities
they can get out of in a hurry. When those doubts go away, the price
investors will pay for liquidity declines, giving the less liquid
small-cap stocks a boost.
* Inflation returns. Yes, this might make the Fed raise rates, which
would be bad for small-cap stocks. But it would help them on another
front. One problem for small-cap stocks right now is that they tend to
do better when there is inflation. They had a great decade in the 1970s,
but have underperformed since inflation peaked in 1980. Why? Because
when prices are going up, small companies can take advantage of one of
their best weapons -- the ability to offer better prices than bigger
companies.
But when the name of the game in business is price cutting to gain
market share, like now, the larger companies tend to have an edge. "When
the big guys start playing the small-cap game and cutting prices, they
just dominate," notes James Paulsen, the chief investment officer at
Norwest Investment Management. Small-cap stocks would benefit from
sustained inflationary pressure that is not quite high enough to bring
the Fed back into action.
No one knows, of course, whether these events or any others will bring
small-cap stocks back. But one thing is clear. If you do believe
small-caps are about to regain their vigor, now's the time to buy, says
Mullins. Because once they catch fire, they move quickly and it is
almost impossible to get them on the way up. "It's like a big rubber
band waiting to snap," says Navellier.
|
