Underweight Small-Caps, JPMorgan Advises - TheStreet

Underweight Small-Caps, JPMorgan Advises

JPMorgan recommends that investors underweight small-cap equities in favor of large-cap stocks.
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BOSTON (TheStreet) -- The stock-market selloff has stoked fears of a bear market.

Skeptics of the rally from the market low 15 months ago are looking like sages. Last week, heavyweight investor

George Soros

called the global sovereign-debt predicament "act two of the crisis."

Many individual investors foresaw a pullback. In fact, they remained remarkably risk-averse during the recovery.

TrimTabs

estimates that there's currently $1 trillion sitting in retail money-market funds earning negligible interest. Investors might heed a call from

JPMorgan Chase

(JPM) - Get Report

: reduce exposure to small-caps and overweight large-cap stocks.

In a 63-page report released last week, the economic-research team at JPMorgan evaluated the strength of the global economic recovery, breaking down the fundamentals of regions, markets and asset classes.

JPMorgan has been among the most bullish of forecasters since the recession hit. The bank still expects above-trend and above-consensus growth, with a projection of 4% annualized GDP growth in the U.S. during the second quarter and 3.5% growth for 2010. Still, JPMorgan has turned more cautious. It noted in its report, titled

It's Complicated

:

"For more than a year, forecasting global growth has been relatively easy. That was then. Now, powerful crosscurrents have entered the scene and are complicating the forecasting process."

Those so-called crosscurrents are threefold: (1) Europe's sovereign-debt crisis, (2) policy-induced cooling in emerging markets, specifically China, and (3) signs of consumer weakness, evident in unemployment and consumer-spending figures in the U.S. Still, the bank says the true risk is from what it calls a potential negative feedback loop generated by markets.

The key takeaway for equity investors: There is concentrated risk in small-cap stocks. Small-caps represent undersized companies. They not only have a higher beta, or market correlation, than large-cap stocks do, but also present liquidity risk because their shares are thinly traded. A block sale can crush the price of an illiquid security. As noted by JPMorgan's researchers, owners of illiquid small-caps have held steady during the correction. Therefore, their portfolios are now overweight in such stocks. If managers attempt to rebalance, especially on a down day, small-caps could suffer a precipitous decline.

The reason for overweighting large-caps is an oft-touted, but sound, strategy: In a downturn, they tend to outperform because of relative safety. In a rally, they typically outperform because of relative value. The

Russell 2000

, a small-cap barometer, tumbled 8% in the past month as the

Dow Jones Industrial Average

declined 5%. This dichotomy of performance illustrates that JPMorgan's prediction is still just that, a prediction. The 3 percentage point discrepancy isn't extreme. However, if fear takes the reins, small-caps are likely to lead markets lower.

Last fall, when the stock-market rally began to lose steam, the Russell 2000 exhibited what's known as a double-top pattern, falling 10% peak-to-trough between Oct. 14 and Nov. 2. The Dow declined just 2.2% over that span, proving its outperformance amid uncertainty.

In the most recent pullback,

IBM

(IBM) - Get Report

,

McDonald's

(MCD) - Get Report

and

Merck

(MRK) - Get Report

are the Dow components that performed best, declining 1.2%, 2.3% and 1.7%, respectively. However, three Dow stocks posted big gains Friday as major indices wavered.

Microsoft

(MSFT) - Get Report

ascended 2.6%,

Pfizer

(PFE) - Get Report

rose 3.7% and Merck climbed 1.7%. All three outpaced the Dow and other major indices. Investors seeking safety and upside should investigate these Dow stocks first. Merck and Pfizer are unanimous value picks, trading at PEG ratios of 0.3 and 0.2 and forward-earnings multiples of 8.9 and 6.5, respectively. Those figures represent the margin of safety that stock investors covet. Based on forecasted earnings, Merck is 36% cheaper than its pharma peer average and Pfizer is 46% cheaper.

-- Reported by Jake Lynch in Boston.

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