(Bloomberg) -- Investors that help oversee $1.6 trillion combined are so confident the new year rally has legs that they’re venturing into one of the riskiest places late in the cycle: Small caps.
Neuberger Berman Group and Legal & General Investment Management are among those defying Wall Street warnings to snap up the volatile, debt-ridden stocks and exploit what may turn out to be the bull-market’s last gasp.
So far, so good. The Russell 2000 Index is up 9.3 percent this year compared to 5.5 percent for the S&P 500 Index, as they emerge as January’s leaders.
Now, their performance is set to deliver a test of the rally’s strength as earnings season gathers pace.
Small stocks have proven a reliable compass for the wider market: They signaled the bottoms for the S&P 500 in 2011 and 2015, and then led large caps out of their troughs, according to Bloomberg Intelligence analysis.
“From here, market participants know that a late-cycle melt-up is always a possibility,” said Erik Knutzen, co-chair of the asset allocation committee at Neuberger Berman. He boosted allocation to U.S. small- and mid-caps to overweight from neutral at the start of the year, as part of the $300-billion asset manager’s push into risk.
A melt-down is also a possibility, one entertained by believers of the “January effect” that says investors starting the year in a buying mood push up prices of the riskiest stocks. Big headwinds for smaller companies -- 40 percent of which are still in cash-burn mode -- are gathering in slumping earnings estimates, a slowing global economy, and rising rates.
Legal & General’s multi-factor team started buying small-cap shares last week as many peers hunker in blue-chips in anticipation of the next downturn. While U.S. large-cap stock funds added $400 million of cash in the week through Jan. 23, just $28 million went into small caps.
“Size is relatively attractive on the valuation front and investors seem to focus more on the large stocks,” said Andrzej Pioch, a money manager at the firm, which oversees 985 billion pounds ($1.3 trillion). “We would normally consider the market sentiment as the contrarian indicator, making us more comfortable about small caps."
They also offer tantalizing valuations. December’s sell-off has swollen the premium of the Russell 3000 Index over Russell 2000 to the highest since at least 2006.
“The market dislocation in the fourth quarter created value opportunities that are attractive despite the elevated risk,” said Olivia Engel, the chief investment officer for active quantitative equities at State Street (NYSE:STT) Global Advisors. She’s eyeing some beaten-up small-caps, especially utilities with track records of decent earnings, but so far hasn’t added to her holdings.
According to Bank of America Corp (NYSE:BAC).’s January survey, 48 percent of investors still expect large-cap stocks to outperform small caps, but that’s down from 55 percent in December.
“If you think markets can go up, small caps give you more exposure and more contribution to this upward potential,” said Thorsten Paarmann, a quant portfolio manager at Invesco Asset Management.
Yet strategists at UBS Group AG and BofA say it’s not the time to be tempted by small caps and advise investors stick to safer bets in blue-chips.
“Ultimately we find sentiment-reversal rallies are short-lived,” said Manish Kabra, head of European equity and quantitative strategy at BofA. Small-cap performance will suffer in “a material slowdown in profit growth” this year, he said.
So far, fourth-quarter earnings in the U.S. have been mixed, with 57 percent of companies beating sales expectations, but with major companies like Caterpillar Inc (NYSE:CAT). and Morgan Stanley (NYSE:MS) disappointing analysts. The U.S. economic expansion is also expected to be less robust this year, while the partial government shutdown is likely to have sapped growth in the first quarter, according to the latest forecasts from JPMorgan Chase & Co (NYSE:JPM). and Barclays (LON:BARC) Plc.
In this uncertain environment, Irina Sidorovitch, head of quantitative portfolio management equities at DWS Group, is focusing on small-cap firms with better quality characteristics.
“Small caps have a higher sensitivity to the risk perception in the market,” she said. “Our portfolios traditionally have some tilt towards smaller-cap companies because they have higher growth expectations and alpha opportunities.”
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