Small-cap stocks double Dow Jones Industrial Average. Is economy gaining speed?

Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.

Oct 28, 2013 @ 8:34 am (Updated 8:43 am) EST

Bloomberg

The smallest stocks are rallying almost twice as fast as bigger companies in the U.S., a bullish economic signal from businesses whose profits are most dependent on domestic demand.

Shares of companies from Rite Aid Corp. to Teledyne Technologies Inc. in the Russell 2000 Index have advanced 32% this year, compared with 19% for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.

Gains in smaller companies that are more dependent on U.S. growth show investors are betting the world's largest economy will pick up even after jobs growth slowed and the government shutdown weighed on gross domestic product. Smaller firms are surpassing analyst earnings estimates by more than Dow companies and are forecast to grow faster next year.

“If you're focused on the U.S., and the U.S. is performing very well, then of course your revenues and earnings are going to be much better,” Kully Samra of Charles Schwab Corp., which has $2.15 trillion of assets globally, said by phone Oct. 24 from London. “Other regions are at different stages of dealing with structural issues, and the U.S. has already dealt with them.”

The average company in the Russell 2000 gets 84% of its sales from the U.S. and is valued at $972 million, compared with 55% and $152 billion for the Dow, data compiled by Bloomberg show.

THIRD GAIN

The Standard & Poor's 500 Index climbed 0.9% last week to 1,759.77, its third straight advance, after a weaker- than-forecast jobs report spurred speculation the Federal Reserve will maintain stimulus. More than $2.3 billion went into exchange-traded funds that invest in U.S. equities Oct. 21 through Oct. 24. The iShares Russell 2000 ETF attracted almost $500 million, the second-most among about 500 funds, according to Bloomberg data.

Rite Aid, the third-largest U.S. drugstore chain, raised its profit forecast last month because of increasing sales at remodeled stores. The Camp Hill, Pa., company gets 100% of its sales from the U.S. and has rallied 276% this year.

Teledyne Technologies, which gets 80% of its revenue from the U.S., raised its 2013 per-share earnings projections last week. The Thousand Oaks, California-based aerospace and defense electronics provider, up 39% for the year, exceeded analyst projections by 8.1% last quarter, data compiled by Bloomberg show.

Small-caps have outperformed since the bull market began in March 2009, climbing 226%, compared with 138% for large-caps. Furniture store Pier 1 Imports Inc. and Dana Holding Corp., a maker of car and truck axles, led the Russell 2000, advancing more than 11,000% each. The biggest gainers in the Dow during the period were American Express Co. with a 676% gain and Walt Disney Co., which rose 344%.

ACCELERATING RALLY

The advance in small companies has accelerated in the last four months, with the Russell 2000 rising 14% since June 30 compared with 4.4% in the Dow industrials. The gap is the biggest for any similar period since 1997, according to data compiled by Bloomberg.

“The main driver of small-caps is the cyclicality of the market,” Patrick Moonen, who helps oversee about $240 billion as senior strategist at ING Investment Management in The Hague, said by telephone. “What are the economic prospects and how are risk aversion or risk appetite evolving? Both factors were clear tailwinds for small-caps so far this year.”

Smaller companies usually climb faster at the start of a bull market, making them a proxy for future economic activity. The Russell 2000 was up 71% in the first six months of the 2009 rally, compared with a 46% advance in the Dow. This year's outperformance is occurring almost five years after stocks started rallying, signaling the economic recovery will accelerate from what has been slowest rate since World War II.

U.S. GDP will increase at a 2.4% annual pace this quarter and reach 3% a year from now, economist estimates compiled by Bloomberg show. This month's budget impasse will spur Fed policy makers to wait until March to scale back the $85 billion of monthly bond purchases, a Bloomberg survey showed this month.

“We have a window of three to four months where we have improving fundamentals and low or no risk of tapering,” Mr. Moonen said. “We are in a sweet spot in that we don't see any major hurdles before the end of the year now that the U.S. fiscal situation is out of the way.”

Russell 2000 companies are beating analyst earnings estimates by 11%, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg. Results for bigger companies fell short of projections in the second quarter, as the smaller companies surpassed forecasts. Analysts say small companies will boost profits at more than four times the pace of larger firms next year.

Those projections are too optimistic and valuations will get too high as brokers lower their profit predictions, according to Steven DeSanctis, Bank of America Corp.'s strategist for small-cap equities in New York. The Russell 2000's price-earnings ratio increased 52% this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.

“It seems a little too optimistic,” Mr. Desanctis said by phone. He predicts the Russell 2000 of smaller companies will end this year at 1,100, or 1.6% lower than the close on Oct. 25. “At the start of the year, valuations were attractive. Not so much today.”

Earnings and economic reports don't justify small-cap prices and shares of larger companies won't necessarily follow the Russell 2000, according to Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees about $364 billion.

“The arrows are not pointing in the direction that suggests that large-cap stocks have to follow their small-cap brethren,” he said by phone on Oct. 23. “Based on the earnings that we have so far, it appears that economic growth is not as robust as what we hoped for at the beginning of the year.”

PAST INDICATOR

Small-cap gains of this size have proven prescient in the past. They preceded faster economic growth and a broader stock market advance in 2003 and 1991, and coincided with them in 1979. The Russell 2000's outperformance in 2003 was at the start of the last equity bull market, when the S&P 500 more than doubled from October 2002 through October 2007. GDP expanded at the fastest rate in four years in 2004.

In 1991, small-caps were up 36% through Oct. 25, more than twice larger stocks, at the start of the largest bull market on record. The S&P 500 gained more than 300% from 1990 through 1998 and the economy grew at an average of 3.5% per year throughout the decade.

“Historically the trend has been for the small-caps to hand the baton off to the large-caps,” Donald Selkin, who helps manage about $3 billion as the New York-based chief market strategist at National Securities Corp.

While confidence among U.S. small businesses slipped in September, it has hovered near a one-year high the last five months. The National Federation of Independent Business's optimism index rose to 94.4 in May, the highest in a year, from 88 in December, according to data based on a survey of more than 770 small-business owners. The number of firms projecting sales will increase and saying it's a good time to expand rose from August.

Analysts predict earnings at International Business Machines Corp., which gets more than half its sales from abroad, will climb 10% this year, the slowest since 2004. Shares have slumped 7.7% in 2013. Caterpillar Inc., where more than 60% of sales is from overseas, cut its 2013 revenue forecast last week. The biggest maker of construction and mining equipment is down 5.4% in 2013.

“If you think the U.S. is recovering, then small-caps tend to be more domestically oriented than large-caps,” Frances Hudson, an Edinburgh-based strategist at Standard Life Investments Ltd., which oversees about $278 billion, said by phone. “Small-caps are more growth-oriented.”

(Bloomberg News)

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