If you've had money in the average fund that invests in large-company stocks, you've made about 1.4 percent this year. But if you're enamored with the edgy, smaller companies that delivered tremendous gains last year, you've probably felt some pain lately.
Small-company stocks, which have been the darlings of the market for the past few years, started sinking in early March. The Russell 2000 index, which reflects small-company stocks, is down about 9 percent since then, and Internet stocks such as Twitter have plunged more than 50 percent since last year.
Because downturns in smaller-company stocks can be precursors to widespread declines in the market, the shift has been eyed as a possible early warning signal for investors. Yet, a common view among analysts is that the broad stock market remains in an ongoing "bull" — or climbing — market.
The Leuthold Group notes that it's not unusual this time of year for small-company stocks to perform poorly. That's a frequent pattern between May and November annually. Meanwhile, the broader stock market still looks sound, according to Leuthold research.
Still, beyond the time of year, there is good reason for small-company stocks to be on the decline. Small-cap analysts say the sell-off of smaller-company stocks is reasonable given the excessive enthusiasm investors have shown for them over the past couple of years. The stock prices climbed to historically high levels compared with the profits that smaller companies are likely to produce in the next year.
Even now, the stocks remain pricey and could slip more, said analyst Steven DeSanctis, of Bank of America Merrill Lynch. But he thinks the worst of the decline is over and if economic news improves the stocks "should perk up."
Despite a surprisingly weak stretch in the economy during the first quarter, the prevailing view among economists is that the second half of this year will be stronger. Many economists anticipate improved employment, gains in housing and more capital spending by businesses on new equipment and production facilities.
But Mizuho Securities economist Steven Ricchiuto notes the expectations might be overdone. A key to the forecasts is the assumption that central banks in Europe, China and Japan will stimulate their economies soon through approaches similar to the Federal Reserve's quantitative easing.
"It is hard to assume that central bankers in multiple regions are all going to adopt more radical policies all at the same time," Ricchiuto said.
Small-company stocks are highly dependent on the strength of the economy, and prices ran up sharply last year on the expectation of a strong economic upturn. Investors favored small stocks over large stocks, and especially those that drew investors to the sharp momentum of climbing stock prices and growth of new technologies. That's changed lately and investors have been shunning the high-growth momentum stocks and favoring the cheaper, solid large companies like telecommunications companies, which they ignored last year.
"April was unkind to smaller firms, as the Russell 2000 experienced its worst monthly return since May of 2012," said Phil Segner, in a Leuthold Group report. Investors have been disappointed by earnings and sales at a time when small-cap stocks have been selling at a 19 percent valuation premium over large-company stocks.
In 2013, investors enjoyed a 38.8 percent return on the small company stocks that make up the Russell 2000. Those with tremendous growth expectations gained 43.3 percent, while the cheaper slower-growing small companies — known as "value" stocks — gained 34.5 percent. In contrast, the large companies of the Standard & Poor's 500 index gained 32.4 percent.
As investors became nervous about the prices they paid for fast-growing companies, biotechnology stocks plunged 27.4 percent, DeSanctis said.
Small-company stocks are reporting better earnings growth than large, solid companies — 8.8 percent compared with about 5 percent for larger companies. And revenue growth is 8 percent versus 2.6 percent, said DeSanctis. But he said the problem for small companies is that fewer are reporting earnings better than analysts were expecting. And only 25 percent have beat expectations for both profits and sales growth.
"Even though the Russell 2000 has experienced a 10 percent correction, valuations have not fallen all that much," DeSanctis added. "And investors are still struggling to find cheap stocks."