For the smallest U.S. stocks, the bear is back

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As bad as it may feel to be in stocks this month, most major U.S. market indexes have given back only a portion of their July gains, not all of them.

The exception: an index of microcap shares, which are the smallest of small-company stocks. That index, the Russell microcap, closed at 83.69 on Monday, falling below its previous summer closing low of 84.11 on July 6.

That means microcap issues are back in a bear market, if you use the strict bear threshold of a 20% decline in prices from their recent peak. The Russell microcap index now is down 21.8% from its 2010 high reached in late April.

The iShares Russell Microcap Index fund, an exchange-traded fund that tracks the index, likewise is down 21.9% from its April high.

By contrast, other major market indexes are holding the bear at bay so far. The Russell 2,000, a broader small-stock index that includes more substantial small companies, at Monday’s close still was 2.1% above its early-July low and down 18.8% from its April high.

The Standard & Poor’s 500 index of the biggest U.S. stocks on Monday was 4.4% above its early-July low and down a relatively modest 12.3% from its April high.

The smallest stocks tend to swing more wildly than bigger stocks in good markets and in bad, of course, because it doesn’t take a lot of buying or selling to move the price needle. And though August is always a thin month for stock trading, this month has been exceptionally slow.

But investors also may be finding it harder to justify hanging on to microcaps based on expectations for the economy. If you’re increasingly worried about the U.S. falling back into recession -- and many investors clearly are -- you’re likely to be more fearful of companies that are heavily dependent on the domestic market for sales and earnings.

That describes many microcap firms, compared with multinational companies that have large foreign operations.

Within the Russell microcap index, many of the stocks that have led the decline since April are consumer-oriented issues such as McCormick & Schmick’s Seafood Restaurants Inc., snowmobile maker Arctic Cat Inc. and retailer Big 5 Sporting Goods Corp.

“We’re not in the ‘double-dip’ camp, but we see growth harder to come by” in the economy, said Steve Wood, market strategist at Russell Investments, the keeper of the Russell indexes. Given that outlook, he said, “We see investors favoring larger-cap stocks for consistency of earnings growth.”

If you believe the U.S. will avoid another recession, however, some microcap stocks should be getting much more attractive as they slide, said Satya Pradhuman, who heads small-stock research firm Cirrus Research.

He thinks tight credit market conditions will loosen further in 2011, making it easier for smaller companies to borrow.

Noting the 29% surge in the Russell microcap index from early February to late April of this year as optimism about the recovery blossomed, Pradhuman argues that “you’ve got a heck of a small-cap rally in the making” if he’s right about the economy and the credit markets.

But microcap stocks trade more on hope than anything else, and right now the shares are up against economic data that have mostly been draining hope, not feeding it.

-- Tom Petruno