Wall St The Week Ahead: US small-caps are likely to pick up again

THERE are many reasons for the sharp underperformance of small-cap stocks in the past six weeks, but the recent correction may be winding down, which means investors worried about a broader sell-off might be able to breathe more easily.

The Russell 2000 briefly dipped into correction territory – down 10 per cent from its March peak – two days after the Dow Jones industrial average and the S&P 500 closed at record highs.

That divergence is uncommon. It has caused some to fear that a strong selloff in large-cap stocks will follow, painting an all-around dire picture for equities. Some investors don’t see it that way, though. They believe that improved economic growth and rising merger-and-acquisition activity should halt the decline in smaller-cap names.

“Growth in small-cap business is still intact, and they will continue to do well,” said Gary Bradshaw, of Hodges Capital Management, Dallas.

The slide in small-cap companies’ stocks might be more related to valuation than any bigger signal on the economy or aversion to equities. The small caps had an outstanding run in 2013 that made them look vulnerable, and this past earnings period made that all too clear.

At the end of 2013, the difference between the forward price-to-earnings ratio on the Russell 2000 and the S&P 500 was near its highest going back to at least 1978, according to data from Citi. The Russell’s forward P/E ratio was 24 then and the S&P 500’s was 15.7. Now the Russell’s forward P/E ratio is 21.5 and the S&P 500’s is 15.3. That’s still a substantial difference.