Droves of enthusiastic proponents bullishly shrieking about small-cap stocks as though they were the collective messiah these past few months have failed to convince most investors to embark on a small-cap buying splurge. So what will stock-pickers do this year, now that some of those small-cap strategists are having second thoughts?
Can't say for sure, of course. But from the 1999 outlooks of small-cap and overall market mavens, there doesn't appear to be a tremendous amount of confidence that the small fry will outperform their big-cap and blue-chip siblings. Several strategists are downright tepid in their calls.
Last year was supposed to be the Year of the Small-Cap Comeback. Instead, 1998 was another dismal year for the group, making the
-- the most widely watched proxy for the performance of stocks with market caps below $1 billion -- the punching bag, the punchline and the laughingstock of the market's major indices. In the face of a 16% pop for the
Dow Jones Industrial Average
, a 40% surge for the
Nasdaq Composite Index
and a 27% gain for the
, the Russell sagged 3.4%.
Add that loss to trailing gains over the past two years -- in 1996, the Russell's 14.8% advance lagged behind the Dow's 26% advance; in 1997, the Russell's 20.5% advance lagged behind the Dow's 22.6% advance -- and you get a bad rap that's only been getting worse.
But share price isn't the only factor in the investment world, and looking ahead, the most prevalent argument for a massive movement in small-caps in 1999 is that they're cheap relative to big-capitalization names. Value, value, value.
In mid-December, the Russell 2000's price-to-earnings ratio relative to the S&P 500 was at its lowest level since 1991, notes William Keuffel, market strategist at
Optima Investment Research
in Chicago. That year, the Russell outperformed the return on the S&P by about 16%; in 1992, it beat the S&P by roughly 12%; and in 1993, it outpaced the S&P by about 10%.
Another argument in favor of smaller companies is that they're less prone to foreign economic downswings than are bigger companies. Considering the high number of companies that issued profit warnings last year due to weakened demand resulting from global economic softness, logic says smaller companies should earn more, relative to their size, than their big-cap counterparts.
On the downside, the domestic economy -- of utmost importance to small-cap performance -- isn't exactly on fire right now, and many economists are calling for lukewarm economic growth in 1999.
Bond Market Association's
10-member Economic Advisory Committee expects
gross domestic product
to average a 2.1% growth rate in 1999, as measured from the fourth quarter of 1998 to the fourth quarter of 1999, much lower than the 3.4% GDP growth rate the economists predicted for 1998.
Also, at least for now, liquidity is helping drive the stock market. That's not good for small-caps, since they're not exactly known for their liquidity. And a good number of analysts expect more volatility in 1999 -- like we didn't have enough of that last year -- and volatility is decidedly anti-small-cap. Investors tend to feel safer holding a big-cap, well-known stock in an uncertain market.
Taking these variables into consideration, market strategists say it's tough to call the future for small-caps. While the Uber-bulls are still out there grazing for more value, several strategists say they're losing faith that the small-caps will conquer the globe next year. Here's a sampling of what small-cap bigwigs are thinking:
Pradhuman: 'More Constructive than 1998'
Satya Pradhuman, director of small-cap research at
, said in a recent research report that although small-cap valuations are at a 20-year low, a "selective approach is warranted" for 1999, which he described as "a more constructive year than 1998." Not quite a hooves-plowing-through-the-dirt, raging bull.
Pradhuman suggested that investors focus on high earnings visibility, meaning consistency and predictability of earnings. Currently starring on Merrill's "SmallCap Endeavor List" are:
Ethan Allen Interiors
Furniture Brands International
Mott: Decreasingly Confident
Claudia Mott, small-cap strategist at
, says she hasn't started off bullish on small-caps in four years, but that during the third quarter she became convinced that the sector, bursting at the seams with value, was starting to turn around. Since then, she says, "nothing's been following through," and she has become decreasingly confident there will be a small-cap rally.
After doing some number-crunching about a week before Christmas, she says her top concern is that small-cap earnings will lag behind large-cap earnings. She also worries that the large-caps will experience an "expansive correction" beyond what they've already encountered, in which case she sees the broader market pulling back.
"If the small-caps lose their profit-growth edge, we'll have a tougher time arguing there's an advantage there," says Mott, adding that her latest figures put fourth-quarter earnings growth at 3% to 4% for large-caps and flat for small-caps. "And that's a risk we have staring us in the face. That kind of profit is not going to excite a lot of people."
Along with having "decent earnings and screaming bottoms," Mott argues small-caps have several factors going for them: They don't rely on foreign investors and economies the way large-caps do; they've been an overlooked play for years; and they're ripe to take the lead as Dow components warn of earnings below year-ago figures while their share prices become prohibitively more expensive.
"For the past two years, the market has been driven by investors tripping over themselves demanding for big-cap stocks -- that has to open the door for mid- and small-caps at some point. We're talking record low valuation," Mott says. "After the third-quarter correction, it was like, 'Oh my God, I'm not making 30% returns like I thought I was.' So I think people will spread their sites once they see how expensive it gets to keep going the way they're going. But there's always that obstacle of fear, fear of being in anything that's not really, really liquid."
Though Mott won't recommend any individual stocks, she says that, as is the case with the rest of the market, small-cap champions are in technology, retail and health care and that they will remain among the outperformers this year. "The market continues to be biased to growth names, as opposed to the value side."
It's typical for small-caps to show strength at the beginning of the year, especially following a down year, she says. "I'm looking for a strong January -- that would be some compelling support. And if that doesn't happen, I'm throwing in the towel because they can get cheaper. We've learned that."
Mullins: The Bull
L. Keith Mullins, emerging-growth strategist at
Salomon Smith Barney
, remains bullish on small-caps, recently commented in a 1999 outlook report: "There's a building body of evidence that the recent pole position taken by the smaller stocks can be sustained for a considerable period of time.
"Equally encouraging stands the fact that small stocks have recently beaten larger-cap issues in both rising as well as falling equity markets," said Mullins. "Their consistent relative strength suggests additional outperformance ahead." He added that the Russell 2000 outperformed the Dow in seven of the nine weeks following early October.
Mullins also argued that flat earnings projected for the S&P 500 over the next two years can only help the small-cap market. "The last such expansion occurred during the earnings slowdown in the early 1990s for the larger-cap stocks as recession afflicted larger-cap profits," he said. "While a recession may be unlikely today, the likelihood of a meaningful earnings slowdown among the larger-cap stocks has only increased over the past few weeks."
Selectivity Is the Key, Again
Other strategists, meanwhile, offer up the notion that the best way to dip the investing toes into small-caps in 1999 is with selectivity.
John K. Lynch, director of investment strategy at
, says, "I really think it's going to come down to a stock-picker's market." He says small-caps offer investors opportunities thanks to largely domestic exposure, low valuations and a reduction in capital-gains taxes, but he suggests investors focus on selected stocks because he doesn't know if "there's enough of a tide to lift all boats." Among some of the small-cap stocks on IJL's recommended list are
Galey & Lord
And then there are the market participants who argue that small-caps suffer from the coiled-spring syndrome: When they take off, they'll take off big. The problem with that?
"You don't know when it's going to be," says Ted Bridges, vice president and money manager of
Bridges Investment Counsel
in Omaha, Neb. "The large-caps have been so good to us, it's hard for us to leave."