Small fry have led the market's rebound, but can it last?

Raise your hand if you missed the small-cap rally.

After sinking in line with the rest of the market for most of last year, shares of many small- and mid-sized companies surged in the last six weeks to spearhead the market’s year-end rebound off its late-November lows.

The small-cap burst has raised hopes that a healthier 2009 might be in store for the sector -- and the rest of the market. Smaller stocks typically take the lead in new bull markets.

From the Nov. 20 market trough through Monday, the small-cap Russell 2,000 index zoomed 31.1% and the Standard & Poor’s 400 mid-cap index advanced 32%. The big-cap S&P 500, by contrast, climbed 23.3% in the period.

"We had a really nice little Santa Claus rally," said Lori Calvasina, U.S. small- and mid-cap equity strategist at Citigroup Inc.

The year-end spurt helped small caps outperform larger shares in 2008 -- an uncommon occurrence given that smaller stocks normally lag during recessions.

For the year, the Russell 2,000 fell 34.8% versus a 37.3% tumble for the S&P mid-cap and 38.5% drop for the S&P 500.

But the small-cap rally poses a dilemma for investors who have been on the sidelines waiting to get back in: The lightning-quick recovery raises the risk that potential buyers are too late.

Small-cap stocks historically have bolted higher in the years following sharp downturns, according to research by Calvasina. The sector has notched an average gain of 51% in the 12 months after bottoming out in a recession or market panic, using data going back to the Great Depression, she said.

So if this rebound turns out to be about average, investors already have missed more than half of it.

"There’s a short-term risk that maybe this bounce has sort of run its course," said Satya Pradhuman, director of research at Cirrus Research in Tarrytown, N.Y.

Pradhuman recommends against chasing the small-cap market now. The worst isn’t over for the economy and financial system, he said. And although he believes small-cap indexes won’t drop below their Nov. 20 lows, he thinks many of the stocks could drift back to more affordable territory.

-- Walter Hamilton

Photo credit: Monterey Bay Aquarium

Comments

[mr.bilko]

Pradhuman is right, the worst isn't over. On Thursday chain stores begin releasing Dec'08 sales data. Thursday will mark the beginning of the January slide. Don't be surprised if Jan indexes hit the lows reached in Nov'08. 2009 feels a lot like 1991-92 with unemployment peaking, banks going bust due to bad real estate picks, house prices plunging, a flat market and a stagnant economy.

[Misty]

I'm not sure this year can compare against 'historical' recoveries in the past. The situation is more global in nature. When even 'safe' or 'contra' investments are not working, you may believe you have a large problem on your hands.