Small-cap stock rally's next leg depends on Fed
SAN FRANCISCO (MarketWatch) -- An extended rally in small-cap stocks, whose support is considered key for a broader market recovery, may hinge on whether the Federal Reserve rolls out new lending incentives that usher in more small-company mergers.
Even though small-cap stocks are lagging the broader market this year, they are still on track to recapture their highs of the year, and they've been making up for lost time during the last few weeks.
The Russell 2000
-- made up of the smallest 2000 companies in the Russell 3000 index (RUA) and is tracked by the
In August, however, the Russell 2000 has risen 3.5%, compared with the S&P 500's 2.2% gain and the Dow Jones Industrial Average's (DJIA) 0.7% rise.
As a general rule, broader market rallies are not considered to be solid unless there's support from their small-cap counterparts. The S&P 500's recovery off its early June lows -- amounting to a roughly 10% gain -- has shifted attention to small caps, and whether their recent bounce can last.
"The broader the rally, the more relevant it is," said Eric Marshall, portfolio manager of the
Supporting momentum from small-cap stocks may come in the form of bank lending incentives from the Fed, according to Michael Jones, chief investment officer of RiverFront Investment Group. Such measures could be announced at the Federal Reserve's retreat in Jackson Hole, Wyo., later this week or at the September Federal Open Market Committee meeting.
With about $1 trillion in excess reserves at U.S. banks, Jones believes Fed Chairman Ben Bernanke will use one of the least controversial tools at his disposal, and give banks the incentive to lend out those reserves, similar to a plan implemented by the Bank of England in July. Read more on the BOE's lending program.
U.S. companies are more likely to use this new funding to go out and buy up their smaller-cap competitors, effectively making many components of the Russell 2000 buyout targets, Jones said.
"Think where there's loan demand," Jones said. "It's not going to property and equipment, so it'll go more to M&A activity for small-caps. This is good, safe lending."
The Fed could encourage banks to act by lowering or eliminating the 25 basis points in interest on excess reserves the banks keep at the central bank.
And while some bargains may be drying up, valuations are still low enough to make several small-cap companies attractive acquisition targets, according to Marshall at Hodges.
A focus earlier this year on macro fears coming out of Europe caused investors to mis-price small-cap stocks, he said.
By early June, the Russell 2000 had fallen nearly 13% from its 2012 high reached in March of just over 846. Its 50-day moving average, which had surpassed the 200-day average in early February during a first-quarter surge for the index, threatened to cross below it in late July. The index closed up 0.5% at 814.28 on Tuesday.
"Stocks were mis-priced because people were focused on Greek and Spanish bond yields and less focused on company fundamentals," Marshall said. "Those kinds of market inefficiencies get exaggerated in the small-cap space."
But as companies started reporting better-than-expected second-quarter earnings in July, small-cap stocks benefitted as the focus shifted back to company fundamentals, he said.
The Hodges Small Cap Fund, which is weighted heavily toward the consumer discretionary and industrial sectors, includes such stocks as
The fund is up about 17% for the year, and 5.1% over the last month.
Unlike Jones, Marshall sees Fed action as being less of a prerequisite for merger and acquisition activity in the small-cap space.
"Anything that provides an incentive for risk can be thought of as a positive," Marshall said. "But M&A makes sense now even without Fed action because you can still find pockets of growth in small caps."
As the economy cools, large- and mid-cap companies are finding it harder to grow organically and may have to start turning to buying small-cap competitors with more robust growth rates.
Marshall expects the small-cap rally to continue barring a catastrophic event out of Europe that would dry up capital, or some intensified government involvement at home that would hamper investment.
It's the higher-than-average volatility of small-cap stocks, however, that keep some people from being as optimistic about the recent bounce back.
"I'm skeptical of the current rally because overall earnings expectations remain high for 2013 and the U.S. economy is still digesting the economic deceleration," said Alan Gayle, senior investment strategist for RidgeWorth Investments. While valuations are acceptable in the small-cap space, they are not cheap, he added.
According to Gayle, small-cap stocks are being supported by hopes of some sort of incremental quantitative easing from the Federal Reserve and a surprise increase in July jobs data.
Even so, small-cap stocks tend to be more vulnerable to recalibrated earnings estimates, and it's that sort of thing that Gayle believes will cut the small-cap rally short as the economy cools.
Small-cap companies will either begin issuing more cautious outlooks or drop them altogether, forcing analysts to fill in the blanks and guide lower, Gayle said.