Saturday, September 12, 2009

Small caps resurgent

In recent weeks, and overwhelmingly in the last week, U.S. small caps have been leading the way. Following three Fidelity run 10bp expense ratio index funds here, S&P 500, Total Return(roughly Russell 1000), and Extended Market(roughly Russell 2000), the Extended Market Fund has significantly outperformed in recent weeks.

One of the much discussed anomalies of the entire rally since March 9th has been the outperformance of higher risk equities, many small cap, relative to large cap bellweathers like JNJ that have fortress balance sheets and outstanding businesses. It appears that there are three reasons for this. First, many of these smaller stocks fell much more dramatically during the period of near financial collapse as their financial flexibility, code for access to liquidity, was in doubt. Second, the extent of many small caps fall led to the more speculative, risk tolerant investors to come in and take a flyer on baskets that could potentially bring outsized returns in the aggregate. Third, now that there has been a run-up, we are entering a period in which the M&A market is heating up as cash on the sidelines at large corporates and with private investors is getting antsy and active. Investors in small companies with competitive product niches could be loathe to part with their investments and risk forgoing a merger premium that may be in the offing.

The market will no doubt eventually tell us whether this thought process is flawed.


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