The bull market of 1998 was great for large-cap investors and portfolio managers, but it was miserable for many small-cap managers and traders.
Getting investors to even notice the best small caps was about as easy as convincing the market that Internet stocks were overvalued, or that Cisco (CSCO) was a sell; it just wasn't going to happen.
The problem was liquidity, or the lack thereof. And it was an odd problem to have, considering that U.S. markets were seen as the safe haven for the world's capital.
Has Santa gone loony?
Will 1999 be the year for small caps?
Merry Christmas, Internet stockholders!
But nervous investors -- namely large institutions and international money movers -- wanted the big names and the certainty of being able to trade quickly during unsettled economic times; small caps are unable to deliver that kind of easy liquidity for portfolio managers who need to trade in large lots.
But all that may soon change.
OUT OF WHACK PREMIUMS
The liquidity problems haven't changed, but small caps have gotten so ridiculously undervalued that in 1999, investors might have no choice but to notice them.
Comparing the price-earnings ratio (P/E) of the Russell 2000 small-cap index with the Russell 1000 index of large caps highlights this value disconnect. Even after the October recovery off the year's lows, the P/E of the small-cap Russell 2000 stood at nearly a 20 discount to its big brother, the Russell 1000 large-cap index -- despite historically trading at a premium.
Jim Oberweis, manager of the Oberweis MicroCap Fund, says that the P/E of his fund is now at a 30 percent discount to that of the S&P 500, even though his fund's growth rate is five times greater.
"It's an incredible valuation differential," he says.
Will this inverted premium disconnect correct itself? Analysts think so.
"It is still my belief that the small-cap market is long overdue for a rally," says Prudential Securities's small-cap guru, Claudia Mott.
Brad Lawson, senior equity analyst at the Frank Russell Company, which produces the Russell 2000 index, adds, "The probabilities of small caps doing better just get bigger and bigger as valuations get worse and worse. It's the old stretched rubber band or coiled spring analogy: When they do bounce, there's going to be a long ways to go."
HISTORY REPEATS
Analysts believe there are several basic reasons why small caps should rally in 1999.
First, small-cap stocks historically perform well after dismal returns like the ones small-cap investors experienced this year. Chuck Royce, manager of the Royce MicroCap Fund, did a study that shows that each of the past six major small-cap downturns of 20 percent or more were followed, in the next year, by periods of extremely high returns.
For example, the correction of 32.7 percent in the Russell 2000 from October 1989 to October 1990 gave way to a rise of 78.9 percent over the next 14 months. The mid-1991 to mid-1992 decline of 20.1 percent was followed by a whopping 116.3 percent gain from August 1982 to June 1983.
Second, analysts say that history favors small caps after Fed rate cuts, which there's clearly been no shortage of in 1998. According to Ms. Mott, for the past 10 periods in which Federal Reserve interest rates have gone down -- going as far back as the 1950s -- the small-cap market has responded positively in nine.
The Fed began cutting rates in late September 1998, which should bode well for small caps in 1999.
Third, high levels of insider buying in small-cap companies tend to be followed by strong performances for those stocks, and records indicate that company insiders have been buying up their own stocks like crazy. In October alone, insider buying of small-cap stocks (as measured by SEC Form 144 filings) increased by 35 percent, according to Frank Ponticello of Prudential Securities.
"In both 1990 and 1994, extreme readings [of insider buying] gave a signal [of oversold conditions], and a new trend in small caps was established for the next three years," says Mr. Ponticello. "It appears at this time we are once again at this inflection point."
Analysts also point to the January effect, which is the tendency of stocks to shoot up at the start of a new year, as another bullish factor in favor of small caps. Investors offset capital gains by selling their underperforming stocks at the end of one year, then look to pick up bargains in January that may have resulted from such heavy tax-loss selling. This makes stocks ridiculously undervalued, which creates attractive targets for fresh money entering the market in January.
Says Satya Pradhuman, director of small-cap research at Merrill Lynch, "The selling pressure may lead to an oversold condition, which can create a very supportive backdrop for a bounce."
THAT'S YOUR VALUE
But the biggest argument of all for small caps in the year ahead is based on valuation, plain and simple.
Listen to Jim Gerson, manager of Hudson Capital Appreciation Fund, a growth fund that invests both in large and small caps: "Given the nature of the markets these last few years, obviously there's more value in small caps. ... From time to time value occurs in large caps as well, but in this kind of market there's much more persistent and widespread value in small-cap companies."
And with large-cap stocks trading at record highs and incredibly expensive valuations, small caps just might find some respect in 1999 after all.
Mr. Hefter is editor of MicroCap1000.com, a news and information Web site dedicated to tracking small- and micro-cap stocks.
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