Ask Bond Investors

William Hester, CFA
November 2003
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The story behind the recent rally in small-cap stocks is one that any struggling high school teenager would enjoy. Smaller companies spent the last half of the 1990's at new heights of unpopularity. They were ridiculed and ignored as investors chased the bigger, better looking growth stocks. But when the decade turned, and with the speed of a changed clothing fad, investors began to spurn big companies, pushing their values down by half. Smaller companies have since become the market darlings.

The current love and affection for smaller companies is well deserved. After sidestepping most of the bear market the Russell 2000 has risen 45 percent this year, nearly double the performance of large companies.

Judging whether this performance will continue, though, is no simple feat. Small cap rallies have been as brief as two and half years (in the early 90's) and as long as 10 years (1973-1983). And the late 90's showed that it's difficult to predict how overvalued the most loved group can become.

So for a sign that conditions for small companies might be weakening, keep your eye on the bond market.

To understand why we need to look more closely at the recent rally. The smallest stocks often run fastest near the end of and immediately following a recession as investor's sense a rebound in the economy and corporate profits. But the group's most recent performance has been extremely lopsided. This small cap rally has not been a rally in small stocks. It's been fueled by the incredible performance of the cheapest and most neglected small companies. The Wilshire's small value index rose 77 percent from March 2000 through the beginning of December. The small growth component dropped 49 percent during that time. Fast growing companies have actually weighed on the performance of the smaller company benchmarks.

A rebound in profits gets some of the credit for the performance of small value stocks. After plunging in recent years, reported earnings will rise 65 percent this year, according to Standard and Poor's. When profits rise strongly value stocks usually do well, with the smallest ones doing best. Since 1978, when earnings have climbed by more than 15 percent a year, small value stocks have climbed 21 percent a year, compared with just 14 percent for large growth stocks.

As profits slow, value stocks lose their edge. In this environment, mid-sized and large growth stocks have done best, rising 18.5 percent and 16.5 percent, respectively, with small value stocks gaining 15.8 percent (small caps usually rally before the recovery in earnings, strengthening the overall results in this environment.)

It's a classic case of survival of the fittest says Richard Bernstein, chief U.S. Strategist at Merrill Lynch. In his book 'Style Investing', Bernstein showed that when earnings growth moderates, managers of growth funds outperform managers of value funds. "Growth managers will tend to outperform as earnings momentum becomes scarce because growth itself becomes a scarce resource, and investors bid up the price of that scarcity."

Enter the Yield Curve

How do you know when the economy is expected to slow? There are a number of useful indicators (see A Brief Primer on Economics), but among the most important are Treasury bond yields. Subtract the 3-month bill from the 10-year note and track the difference. This is the slope of the yield curve, and it's the world's largest barometer of the expectations of US economic growth (Pop Up: The Yield Curve: a multi-talented indicator).

When investors expect stronger economic growth with faster inflation, they'll demand higher yields on long-term bonds. This is the environment where small caps have done well. A flatter curve signals expectations for a slowing economy, and better times ahead for growth stocks, especially larger ones.

Looking at the Wilshire indexes since 1978 in periods of steep and flat yield curves, the performance profiles of various styles are nearly mirror opposites. When the difference between the bill and the 10-year was over 250 basis points (a basis point is one hundredth of one percent) the two best performing groups were mid-sized and small value companies. When the curve flattened to less than 100 basis points, large and mid-sized growth companies performed best and small value companies were the worst performing group.

At 350 basis points the curve is still steep, which has historically been favorable to small caps. But with a long advance already in place and prospects for rising short-term interest rates, keep an eye on the yield curve. It matters to more than just the bond market.