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Is it Time to Stock Up On Small-caps?

6 November 2014 in Trading Ideas

With the market charging higher recently to set yet another high mark for the year, we’ve noticed the familiar sight of small stocks leading the way.

Since Oct. 15, the S&P 500 has climbed more than 7%. But small-caps, as measured by the Russell 2000, have gained more than 10%.

Other small-cap investments have also been strong recently. The Small-Cap Stars motif has gained 9.1% in the past month. During that same time, the S&P 500 has increased 3.1%.

So far in 2014, the motif has risen 6.9%; the S&P 500 is up 11.3%.

When this latest market run started, small-cap bulls were more difficult to find. After all, from Sept. 3 to Oct. 14, the Russell 2000 fell 10%.

However, some prescient analysts were bold enough to make the contrarian call. Morgan Stanley analyst Adam Parker declared on Oct. 14 that small-caps were about to go on an outperforming run for the next year.1

“We really like small caps right now,” Parker wrote in a note cited by the Wall Street Journal. “We wouldn’t short large caps against them, as we think they will appreciate also, but rather we think small caps will outperform over the next 12 months. One catalyst might be better relative earnings revisions, spurred by less exposure to the strengthening dollar. More potential margin expansion, faster growth, and being a clear beneficiary of increased M&A would also help.”

Analysts at Bank of America Merrill Lynch also recently said they favored small-caps as a play on the impact of a stronger dollar via the decoupling thesis – the idea that the US will continue to improve economically but that Europe and Asia will flounder.2

As the Journal noted, investors have certainly bought into the theory: Between August and October, both US large-cap stocks and the dollar went on their longest winning streaks against overseas assets in two decades, according to Merrill’s report.

The problem for Merrill was that the length of outperformance by both US stocks and the dollar has had “no parallel over the past 20 years.” And, Merrill added, if you focused your investments on big multinationals — the large-caps — avoiding overseas pain is impossible, as was seen in earnings reports last month by Coca-Cola IBM and General Motors.

How to sustain the decoupling strategy? Head for small-caps, Merrill said.

With foreign sales at only 19% of their total, small-caps have lower exposure to both the dollar and overseas growth, the Journal noted. Small-cap earnings also track the US economy more than large-caps, so if fourth-quarter US gross domestic product comes in at 3% (as Merrill’s economics team believes), that could lead to “mid-teen” earnings growth.

For small-cap stock investors, that could mean outperformance has just begun.

1Tom Lauricella, “Morgan Stanley’s Parker: We Really Like Small Caps Right Now,” wsj.com, Oct. 14, 2014.

2Paul Vigna, “A ‘Small’ Decoupling Play for Stocks,” wsj.com, Oct. 23, 2014.