Small-Cap Stocks Could Have Further to Fall

AFTER SLUMPING INTO bear-market territory in January, small stocks remain 19% below their last peak. They've also dipped below their long-term averages by several price gauges, making it tempting to start buying again. But are they cheap enough yet to truly start loading up on?

One way of deciding is to compare the recent drop with those in past downturns. By this measure, a bottom looks near but not quite here. The crux is whether the downturn is just beginning, almost over or yet to come, particularly as inflation pressures build.

The Russell 2000 index, the benchmark for small stocks, has in the past declined an average 32% from peak to trough in bad times, according to Citigroup's small-cap and midcap equity strategist Lori Calvasina. By contrast, the lowest the Russell has gotten so far is 24% below its recent peak — an indication there could be more downside to come.

Small caps also look overpriced compared to large stocks. Large stocks are trading at about 16 times earnings from the last four quarters, whereas small stocks are trading at 23 times earnings, according to the Russell benchmarks. Small growth stocks, trading at 30 times earnings, are the most expensive, while large value stocks (which includes beaten-down banks) are the cheapest at 15 times earnings.

"Small caps still look pricey to us," says David Joy, chief market strategist at money manager RiverSource Investments. "They've begun to correct but have by no means corrected the extended outperformance cycle enjoyed over the past six years."

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Contrary to other economic forecasters, Joy says a real recession is more likely to come in the second half of 2009 rather than this year because the Federal Reserve's interest rate cuts and government stimulus plan will work through the system in the coming months. So, small caps might get a temporary boost in the near term. But looking into next year, "We think inflation is going to be an increasingly difficult problem that the Fed will have to address with higher interest rates and that will push us into recession," Joy says.

Sam Stovall, chief investment strategist for Standard & Poor's, points out that earnings growth is oddly expected to be a strong 18% this year for all the size groups — the large S&P 500, mid S&P 400 and small S&P 600. Some of this is because earnings were weak last year, led by a 6% decline in earnings for small caps, Stovall says. The other factors at play are the Fed's rate cuts, and companies continuing to buy back stock, which boosts earnings per share. So it comes down to price. The S&P 500 is trading at about 14 times expected 2008 earnings, while the S&P 600 is at 16 times 2008 earnings, Stovall says.

Another factor hurting small caps is the tighter credit markets. Small companies rely on credit more than large companies, but in this market banks may be loathe to lend money to less-established companies.