Small caps get hit hard in downturn

Small caps get hit hard in downturn

	Published : Tue, 27 Feb 2007 23:15 By : Agencies Print this Story

NEW YORK (AP) - Small-cap stocks that have beaten the large-cap Goliaths for much of the past decade may have met their match in the market's plunge.

The Russell 2000 index of smaller companies took a painful 3.77 percent hit Tuesday, compared to a 3.47 percent drop in the Standard & Poor's 500. Just a day earlier, on Monday, the Russell was enjoying a 4.6 percent gain since the beginning of the year, while the S&P 500 index was up a comparatively small 2.2 percent.

With plenty of excess cash in the market, investors were willing to take a risk on fledgling companies. But throw in the uncertainties that took the market down sharply Tuesday -- the possibility of slowing economies in the U.S. and China, nervousness about the housing market and overall worries about a stock market correction -- and small caps suffered a bigger blow than other stocks.

For seven out of the past eight years, small cap stocks advanced further than large caps. Investors saw big benefits to these companies: Because they are young and under-the-radar, they are relatively inexpensive and have a lot of potential to grow.

At the same time, their extended advance has made them vulnerable, in part because their high price-to-earnings ratio made them look like less of a bargain than in the past. Jack Ablin, chief investment officer at Harris Private Bank, pointed out that when small caps began outperforming large caps several years ago, their P/E ratio was about half that of large caps. But small caps' P/E ratio surpassed that of large caps.

Even before Tuesday's drop, Ablin was already expecting that small caps would fall short.

'All other things being equal, with the rising tide of liquidity, there's certainly a lot of momentum and inertia behind small cap stocks that could help push those stocks higher. But eventually, over longer periods of time, fundamentals do matter, and we'll see more smaller companies disappoint,' he said.

He noted that the effects of the Fed's two-year tightening campaign are still trickling through the economy and that short-term bonds are yielding more than some longer-term bonds -- which historically signals an economic slowdown. Because of these factors, the forecasts of small-cap earnings growth exceeding 20 percent seemed too optimistic, he said, while forecasts of single-digit earnings growth for large-caps looked more realistic.

Other strategists say the economic conditions are right for a small-cap retreat.

'Globally, we are moving into an economic downshift,' said Steve Wood, senior portfolio strategist at Russell Investment Group, noting that economists are expecting the government to downwardly revise the gross domestic product annual growth rate to 2.2 percent from 3.5 percent when it releases the GDP on Wednesday.

Furthermore, last week, the consumer price index showed an uptick -- which rekindled concerns about the Fed resuming its rate hikes.

'Bankers and so forth are tripping over themselves to lend to the biggest blue chips, but for the most part, having a small company get a loan is comparatively more difficult,' Ablin said. 'Any tightening in credit will impact the smaller players first.'