Wall Street week ahead: Don't leave small-cap stocks for dead

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 selloff 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, portfolio manager at Hodges Capital Management in Dallas.

"Large-caps are flush with cash, and we think there's going to be a lot of acquisitions out of small-caps."

The slide in small-cap companies' stocks might be more related to valuation than any bigger signal on the economy or a sudden 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.

Looking at earnings, large caps have performed better. Just 25 per cent of S&P 500 components have missed expectations for per-share earnings in the first quarter.

By comparison, a Thomson Reuters index of nearly 2,000 companies in the small- and mid-cap space showed 44 per cent have missed earnings forecasts so far, according to StarMine data.

"The most pronounced divergence I am seeing this year relates to quality and consistency of earnings," said Brad Lipsig, senior portfolio manager at UBS Financial Services, speaking of small- and large-cap stocks.

Fear has been part of the equation as well. Investors have shied away from hyper-growth companies since February as biotechnology and Internet stocks slumped. That drove flows away from the iShares Russell 2000 exchange-traded fund, which in turn pressured the underlying stocks.

But the tide may be changing. Weekly inflows into the IWM ETF in the week ended Wednesday were the highest in dollar terms in four years, according to Lipper data.

"If this does stabilize, we could see a turn, with small caps holding up better," Steven DeSanctis, small-cap strategist at Bank of America Merrill Lynch, told clients in a Friday note.