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Strong rally in U.S. small caps may emerge

Small-cap stocks as measured by the Russell 2000 fell into a bear market after dropping 25 per cent in the past month. Some analysts, however, say investors have been too quick to dump shares of smaller companies.

Small-cap stocks are usually the first group of equities to get crushed heading into a recession and typically are the first to recover on a rebound in economic growth. Investors flock to the safe havens of bonds and large-cap dividend stocks. With the Russell 2000's monthly decline outpacing the 17 per cent plunge on the broader S&P 500, investors are now worried about the prospects of a second, more painful recession.

The fears of a double-dip aren't unfounded. First-quarter U.S. gross domestic product, or GDP, growth was initially pinned at 1.9 per cent before being revised a month later to only 0.4 per cent. Meanwhile, the advance read on second-quarter GDP growth was a disappointing 1.3 per cent. While the 117,000 jobs added to payrolls in July was better than economists had predicted, the number is nowhere near what's needed to reduce unemployment. Standard & Poor's on Friday made the unprecedented decision to strip the U.S. of its coveted triple-A rating on concerns over the country's ability to manage its debt.

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In assessing the damage to small-cap stocks, Citigroup analyst Scott Chronert notes that since the Russell 2000 was created in the late 1970s, one-month declines of this magnitude have only occurred four other times: the financial crisis in 2008, the tech-bubble unwind in 2002, Black Monday in 1987 and Silver Thursday in 1980.

"Similar to many investors, we did not anticipate the influence the debt-ceiling debate would have on future growth expectations," Chronert writes in a research note Tuesday. "In this environment, we expect 'growth' to become an increasingly scarce resource."

Among the most hardest hit small-cap stocks on the Russell 2000 have been PMI Group , Insmed , Imperial Sugar , Gentiva Health and Sun Healthcare , all of which fell more than 60 per cent this month through Monday's close. Of the 2,000 stocks in the index, only 29 have gained, with Global Traffic and Staar Surgical rising 17 per cent and 13 per cent, respectively.

On the broader S&P 500, every company with a market cap below $5-billion has seen its stock drop. Among the worst decliners are MetroPCS and AK Steel , each down more than 35 per cent this month.

JPMorgan analyst Bhupinder Singh notes that small caps have already seen outflows from retail and institutional investors. "Since the start of May, investors have already rotated $8.8-billion out of small caps," Singh writes in a research note Tuesday. "Also, macro and [long-short] funds have meaningfully reduced equity exposure to below the long-term average."

Despite the unfavourable indications, a second recession is not a foregone conclusion. Singh says that unless a recession is almost certain, the market is likely overreacting.

"If this is truly an economic downturn, it would be the first recession to surprise the extremely risk-averse bond market," Singh writes, noting that the spread between the two- and 10-year U.S. Treasuries and the spread between the 10- and 30-year Treasuries are still steep. "However, if this is just a technical correction, a strong rally is likely from the current oversold levels."

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Singh notes several other positive characteristics for the beaten-up small-cap space. He points out the potential of a coordinated global policy response to the slowdown in economic activity, which could result in additional accommodative measures. The Federal Reserve meets Tuesday to decide on interest rates, for instance, and the expectation is for the central bank to say it will keep rates low for even longer.

Additionally, Singh says second-quarter earnings have confirmed that fundamentals remain intact despite headwinds. He says small caps managed to post "impressive" top-line growth of 10.7 per cent year over year. If nominal GDP growth remains above 2.5 per cent in the last half of 2011, he expects that top-line growth of 8 per cent or so "is likely to continue."

Singh also argues that valuation is more attractive as price-to-earnings multiples contract, considering many of these companies have the strongest balance sheets on record. "The lowest net debt as a percentage of assets in history means that small-caps are in the best position to endure negative surprises," he adds.

Separately, Citigroup's Chronert also highlights several positives for small-cap stocks that investors may be ignoring. He notes that, in general, the one-, three-, and six-month forward returns from such declines have been positive. However, in this environment, anything is all but certain.

"Nearer term, we expect stabilization, although the intermediate-term picture will likely remain clouded by the increased urgency to address both spending and revenue issues," Chronert writes.

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