'Strong Rally' in Small-Caps May Emerge

BOSTON (TheStreet) -- Small-cap stocks as measured by the Russell 2000 fell into a bear market after dropping 25% in the past month. Some analysts, however, say investors have been too quick to dump shares of smaller companies.

Small-cap stocks are usually the first group of equities to get crushed heading into a recession and typically are the first to recover on a rebound in economic growth. Investors flock to the safe havens of bonds and large-cap dividend stocks. With the Russell 2000's monthly decline outpacing the 17% plunge on the broader S&P 500, investors are now worried about the prospects of a second, more painful recession.

The fears of a double-dip aren't unfounded. First-quarter gross domestic product, or GDP, growth was initially pinned at 1.9% before being revised a month later to only 0.4%. Meanwhile, the advance read on second-quarter GDP growth was a disappointing 1.3%. While the 117,000 jobs added to payrolls in July was better than economists had predicted, the number is nowhere near what's needed to reduce unemployment. Standard & Poor's on Friday made the unprecedented decision to strip the U.S. of its coveted triple-A rating on concerns over the country's ability to manage its debt.

In assessing the damage to small-cap stocks, Citigroup analyst Scott Chronert notes that since the Russell 2000 was created in the late 1970s, one-month declines of this magnitude have only occurred four other times: the financial crisis in 2008, the tech-bubble unwind in 2002, Black Monday in 1987 and Silver Thursday in 1980.

"Similar to many investors, we did not anticipate the influence the debt-ceiling debate would have on future growth expectations," Chronert writes in a research note Tuesday. "In this environment, we expect 'growth' to become an increasingly scarce resource."

Among the most hardest hit small-cap stocks on the Russell 2000 have been PMI Group (PMI), Insmed (INSM), Imperial Sugar (IPSU), Gentiva Health (GTIV) and Sun Healthcare (SUNH), all of which fell more than 60% this month through Monday's close. Of the 2000 stocks in the index, only 29 have gained, with Global Traffic (GNET) and Staar Surgical (STAA) rising 17% and 13%, respectively.

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