Small Cap Stocks: Too Far Too Fast or Just the Beginning?

Stroy sourced from SEI

By: James Solloway, CFA, Senior Portfolio Manager, Global Portfolio Strategies at SEI

“Less-bad” indicators suggest the worst of the recession is over, boosting risk appetite and helping smaller company (small-cap) stocks to rally more than 50% from March lows, which SEI believes will prove to have marked the trough of the bear market (prolonged period of sharp declines).

The dramatic recovery in share prices, while fairly extreme by historical standards, is not out of line for the early stages of a bear-market rebound, and SEI believes it is correctly anticipating an economic recovery. Declines in initial jobless claims and sharp improvement in manufacturing activity suggest “less bad” may lead to “more good” economic indicators.

Data on money-market versus equity exposure suggests investors in general are still slightly pessimistic, leaving room for more money to flow into equities as recovery comes. However, small-cap valuations are not cheap on an absolute basis or relative to larger company (large-cap) stocks, and headwinds remain from continued financial stress.

The makeup of the small-cap market presents good opportunities to benefit from stabilization in the financial system and economic recovery, given large weightings in the Financials, Consumer Discretionary and Industrials sectors. In SEI’s view, some correction would not be surprising after a very strong run, but we believe the worst of the recession is over and credit conditions should continue to improve.

“Less bad is the new good” is the current mantra in the markets. This tagline reflects an economy where the decline is moderating, but the level of business activity remains very weak. While the economic data clearly point to a deceleration in the rate of decline compared to last year’s final quarter and the first few months of 2009, it may take the rest of the year before there is conclusive evidence that a sustainable recovery has begun.






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