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Small-Caps Have an Edge for the Second Half

This post appeared earlier this week on RealMoney. Click here for a free trial, and enjoy incisive commentary all day, every day.

Russell 2000 performance in the first half of 2011 has matched that of the S&P 500 perfectly, with both indices rising slightly more than 2%. This is an acceptable if unremarkable number, yielding an annual return well under 5%. Despite this lockstep behavior, world events predict that small-caps will outperform blue chips from now into year's end, so the actual return may exceed current expectations, perhaps significantly.

Logically speaking, the tight correlation between these divergent indices makes little sense, because small-caps should lag badly in a weak U.S. dollar environment, which favors the S&P 500's currency-sensitive international operations. But that hasn't been the case in the first six months of 2011, so we need to look elsewhere to understand this unexpected alignment.

Of course, the answer lies in the risk-on/risk-off trade that became the dominant hedge-fund play after the implementation of QE2. Dollar downswings since that time have generated buying pressure across the entire spectrum of U.S. equities, tossing small- and big-caps into the same basket. On the flip side, dollar bounces have triggered massive sell programs that dump equities like hot potatoes and park cash into fixed income.

This derivative-driven convergence has defied the typical role of small-caps as risk-appetite instruments, drawing in speculative capital from investors who are seeking out higher-than-average returns. Fortunately, it looks like this correlative strategy is finally coming to an end, with commodities taking the long, slow ride to lower ground while market players refocus their attention on economic issues and individual stock plays.

Dollar Index Daily
Source: eSignal

In addition, currency fluctuations should underpin small-caps in the second half of the year, because the U.S. Dollar Index (DX0) is undergoing a long-term bottoming process. That instrument hit a new low for the decade in 2008 and then bounced strongly. The recovery attempt stalled under five-year resistance in the low 90s, yielding a lower high and deep retracement that found support just above the bear market low.

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