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'Strong Rally' in Small-Caps May Emerge

On the broader S&P 500, every company with a market cap below $5 billion has seen its stock drop. Among the worst decliners are MetroPCS (PCS) and AK Steel (AKS - Get Report), each down more than 35% this month.

JPMorgan analyst Bhupinder Singh notes that small caps have already seen outflows from retail and institutional investors. "Since the start of May, investors have already rotated $8.8 billion out of small caps," Singh writes in a research note Tuesday. "Also, macro and long-short funds have meaningfully reduced equity exposure to below the long-term average."

Despite the unfavorable indications, a second recession is not a foregone conclusion. Singh says that unless a recession is almost certain, the market is likely overreacting.

"If this is truly an economic downturn, it would be the first recession to surprise the extremely risk-averse bond market," Singh writes, noting that the spread between the two- and 10-year U.S. Treasuries and the spread between the 10- and 30-year Treasuries are still steep. "However, if this is just a technical correction, a strong rally is likely from the current oversold levels."

Singh notes several other positive characteristics for the beaten-up small-cap space. He points out the potential of a coordinated global policy response to the slowdown in economic activity, which could result in additional accommodative measures. The Federal Reserve meets Tuesday to decide on interest rates, for instance, and the expectation is for the central bank to say it will keep rates low for even longer.

Additionally, Singh says second-quarter earnings have confirmed that fundamentals remain intact despite headwinds. He says small caps managed to post "impressive" top-line growth of 10.7% year over year. If nominal GDP growth remains above 2.5% in the last half of 2011, he expects that top-line growth of 8% or so "is likely to continue."

Singh also argues that valuation is more attractive as price-to-earnings multiples contract, considering many of these companies have the strongest balance sheets on record. "The lowest net debt as a percentage of assets in history means that small-caps are in the best position to endure negative surprises," he adds.

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