Guarding Against Small Caps' Inevitable Decline

By Chet Currier
Bloomberg News
Sunday, January 29, 2006

To stand your ground as a small-stock investor nowadays, you have to face down some forbidding arithmetic.

Little stocks have been trouncing big stocks for the past six years, from the end of the 1990s through 2005. They did it again in the early weeks of 2006.

Delightful as all this has been for small caps' true believers, it also has left them in a troubling position. If small stocks are going to continue outpacing big stocks the way they have been, they will have to develop an increasing resistance to gravity -- or, more precisely, to the gravitational pull of the force known as reversion to the mean.

The numbers show how big the gap has grown. From the end of 1999 through 2005, the Standard & Poor's SmallCap 600 index climbed 85.9 percent, or 10.9 percent a year, including dividends. During that same stretch, the S&P 500-stock index, dominated by big stocks, lost 6.8 percent, or 1.2 percent a year.

Some of this is payback for the second half of the 1990s, when the 500 index gained 247.4 percent, doubling the 118.7 percent payoff of the small-cap 600. Some of it also stems from strong earnings showings by smaller companies.

"Forward earnings for small-company stocks rose faster than bigger-company ones last year, as they have for the past four years," says Edward Yardeni, chief investment strategist at mutual fund manager Oak Associates Ltd. in Akron, Ohio.

The small-stock stampede ran right over contrarians who began calling at least two years ago for a shift of market preferences back toward big stocks. The object lesson has been hard to miss -- the timing of changes in relative performance among asset classes is no easier to predict than the ups and downs of the market as a whole.

So the small-stock bandwagon may keep rolling for some time yet. The longer it continues, however, the more it will have to defy the pressures of mean reversion.

Think of it this way: As small stocks have outperformed year after year lately, their superior performance hasn't occurred in the dark. It is plainly visible on the stock charts and in mutual fund performance results, where all investors can see them. In these circumstances, it isn't logical to expect that small stocks will or can remain the relative bargain they were at the turn of the millennium.

The same problem has arisen in world stock markets, says Drew Spangler, an analyst and fund manager at Grantham, Mayo, Van Otterloo & Co., in a commentary published this month on the $102 billion money manager's Web site.

"International small caps are expensive," Spangler wrote. "History suggests that from their current levels international small stocks will deliver disappointing relative returns in the future."

Given my argument that investors can't time these moves, what's a small-stock partisan to do now? Those who ignored valuation warnings last year and the year before have been generously rewarded for staying true to the small-stock cause. So it's tempting to sit tight awhile longer. There is one reasonable alternative. That is simply to rebalance, moving enough money out of small-stock funds into some big-stock vehicle to get the proportions back to whatever ratio was called for in your original asset-allocation plan.

If you started out the 21st century with, say, $100,000 in each category, today you may have $186,000 in a hypothetical small-cap fund and $93,000 in a big-stock index fund. To rebalance, you would move about $46,500 from the small-cap fund to the big, so that the two would balance again at $139,500.

Of course, any truly disciplined rebalancer would have been doing that all along -- and the total value of his holdings would be thousands of dollars less as a result.

With rebalancing, as with most any other system, there sometimes is a substantial cost to be paid as you manage risk against reward. That's what makes rebalancing harder to practice than to preach.

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