CHICAGO (MarketWatch) � This spotty economic recovery has fooled more than a few: bad days for bears, good days for champions of small-cap stocks, whose strong rebound just may continue.
In that constant churn between �risk on� and �risk off,� investors have been getting a little more adventurous, and small caps are delivering. The Russell 2000 Index RUT �rose 7% last month, marking its best January since 2006. The Fed�s pledge of low interest rates certainly helps small-capitalization firms, which often have more trouble borrowing than their bigger rivals.
Click to Play Employment has long road to travelMarketWatch columnist Rex Nutting makes the point that despite steadily improving employment numbers in the U.S., we're only halfway through the pain and suffering.
Most economists think the U.S. economy will chug along, with several looking for 2012 GDP growth of around 2% or a little better. That�s not bad for a base case, considering global pressures and timid executives and consumers still smarting from the financial crisis and recession.
The small-cap story is playing out in earnings results. Four of every 10 small-cap companies are beating Wall Street expectations so far this year, and 54% have topped the sales estimate in recent reporting rounds, according to Bank of America Merrill Lynch.
But have small-cap stocks come too far, too fast?
�We are sticking with our [small-cap] return target of 11.5% for 2012 despite the strong gains to start the year, as the U.S. economy is expected to slow in the back half of the year but earnings expectations do not reflect this trend,� said Steven DeSanctis, head of U.S. small-cap strategy at B. of A. Merrill in a recent research report.
�Volatility will rise thanks to Europe, the U.S. presidential election, new fiscal policies, and the Middle East,� he added. �This could put a damper on performance going forward.�
/quotes/zigman/2759624 RUT 800.99, +11.37, +1.44% Running with the Russell
Yet Jeffrey Schwartz, senior portfolio manager of the Pyxis Small-Cap Equity Fund HSZAX , argued that the small caps is precisely where to position a portfolio for domestic economic growth because the space has less exposure to troubled international areas than both midcaps and large caps.
Clearly there may be a few snags to the small-cap thread. That said, with the required caution also considered, here�s a short list of economic catalysts and market sectors where improved conditions should bode well for small-cap stocks:
1. Banking and creditThere�s so much bad news priced into financial shares, �it sure wouldn�t take much to reignite fundamental improvement,� said Lawrence Creatura, manager of the Federated Clover Small Value Fund VSFAX . �Expectations are subterranean. Nobody expects the environment to get much better here soon.�
With pessimism about the economy still prevalent, Creatura is looking closely at smaller banks with a regional focus.
�Pick your region, your management team, the type of lending you prefer, and track lending history,� Creatura said. �Small-cap financials have a huge advantage in this environment to the conglomerate banks.�
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