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As big stocks rise to record, small caps could fall

The Baltimore Sun

The Dow Jones industrial average did it.

After an up-and-down 6 1/2 years, the Dow crossed the 12,000 mark during trading for the first time Wednesday.

But what does that mean for your favorite mutual fund? Perhaps very little.

If you have had a pet U.S. stock mutual fund during the past few years, the chances are that it invests in small companies - not the 30 giant companies that pushed the Dow above its high-water mark.

And with the megasize companies of the Dow gathering attention, some analysts say your small-cap fund could begin to look tired in the months ahead.

Their advice: Look over your funds now, and make sure the sweet returns of your small-cap fund haven't lulled you into ignoring large caps. As a rule of thumb, large companies should make up about 75 percent of an investor's U.S. stock portfolio, and holding large caps now appears especially prudent, because they appear to be building strength.

During the past five years, you would not have missed large caps. On average, large-cap stock mutual funds provided investors returns of only 4.8 percent a year, while small caps climbed 13 percent a year, said Lipper Inc.

But the stock market runs in cycles. Certain groups of stocks stay strong for a while, then recede as another group gains strength. Analysts are seeing signs of a stronger cycle for large companies and an easing of the cycle that has been so good to small caps.

"We think the small-cap outperformance cycle is officially over," said Prudential Equity Group strategist Steven DeSanctis in a recent report. "We date the cycle as lasting from April 9, 1999, through May 4, 2006, which makes this period of outperformance the second-longest in history."

"Small caps are no longer in a leadership position," added analyst Jim Floyd of The Leuthold Group LLC. "Fundamentally, earnings are lagging and valuations are relatively rich."

Compared with large caps, investors are paying a 5 percent premium to buy small-company stocks, he said. That's in contrast to 1999, when small caps were so neglected that investors could buy them at a 40 percent discount.

Now, with small caps so pricey, they would need to decline 25 percent to return to their median historic valuations, Floyd said. In a bear market, he said, they could fall 50 percent. Large companies would probably fall, too, but to return to their median valuation they would only decline 6 percent.

This year, small companies still are outperforming large ones. The Russell 2000 small-cap index is up about 13 percent, while the Dow is up about 12 percent. But in September, the trend showed signs of reversing, with the Russell 2000 up 0.7 percent, compared with 2.6 percent for Dow.

Analysts following large companies have higher expectations for them than for smaller ones, said Merrill Lynch analyst Savita Subramanian.

During the past three months, expectations for the largest stocks have "improved three times as much as they did for the smallest quintile," Subramanian said, noting that optimism for large stocks is the highest since April 2002.

Meanwhile, as investors gained enthusiasm for large caps, the No-Load Fund Analyst newsletter advised mutual fund investors to reduce exposure to funds that invest in small companies and channel money into larger companies.

"Small caps are expensive relative to large caps," said Stephen Savage, the publisher of the newsletter.

Investors could have opportunities to shift some money from small to large during the last quarter of the year. DeSanctis said that while he considers the small-cap cycle over, he expects large and small companies to enjoy a rally in the last months of the year.

Contact Gail MarksJarvis at or leave a message at 312-222-4264.

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