Mid- and small-capitalization stocks often serve as a leading indicator for the direction of the U.S. economy. So what does it say that they are down roughly 15 to 20 percent?
As the U.S. economy throws up dismal economic data, putting the ominous possibility of a double-dip recession at the top of Wall Street's talking points, money managers are saying that assessment would be premature.
Right now the market is responding to this fear, and double-dip is in the air... but is it verified in the statistics? And in that case we are saying 'No, there is no double-dip,' said Milton Ezrati, senior economist and market strategist at Lord Abbett, in Jersey City, New Jersey.
Particularly in an environment like this it is very dangerous because the market picks up the talk and it will give a lot of false signals, Ezrati said, referring to the influence grim economic data can have on stock markets and vice versa.
Risks of a double-dip have increased, managers admit, as employment and housing have failed to rebound, and, akin to the eternal chicken vs. egg debate, corporate earnings estimates are being revised downward in anticipation of sluggish growth.
We are in a transition period where small and mid-cap stocks will face headwinds as they face the question of whether earnings projections will be reduced by a more sluggish global economy, said Martin Sass, founder of New York-based investment advisory firm MD Sass.
Sass believes it is premature to declare a double-dip recession is at hand, but notes that earnings estimates are now being revised down rather than up.
In fact, the mean change in aggregate earnings estimates for the third quarter for the S&P SmallCap 600 index .SML fell 1.1 percent in the last 30 days, according to Thomson Reuters StarMine Professional data.
That is still slightly less negative than the 1.4 percent drop in the last 30 days for revisions to S&P 500 .SPX aggregate earnings estimates.
Stocks have tumbled from their late April peak, entering deep into correction territory even after a strong rally on July 7, when most major stock indexes rose over 3 percent.
According to Canadian investment firm Brockhouse Cooper, over the prior five U.S. recessions, small-cap stocks have outperformed large-cap shares by 4.5 percent, on average between the market trough and the end of the recession. In the first year of expansion that outperformance is 13.7 percent.
The S&P 600 SmallCap index is down 16 percent while the S&P 400 MidCap index .MID is off 15 percent from April 26 highs.
That may be worse than the 13 percent drop in the large-cap S&P 500, however, since the March 2009 market trough, mid- and small-cap stocks are up well over 80 percent versus a 58 percent rise in the S&P 500.
We are not forecasting a double-dip, no, just a slow growth environment. Very slow. We think (small-caps) are going to underperform a little bit, more just because of the relative valuations, said Bernie Williams, the head of USAA's private investment management division based in San Antonio, Texas.
Williams says he sees shares in a trading range, although he remains cautiously optimistic.
If earnings come through and we don't double-dip, we could end up in positive territory for the year, he said.
As a result of their run-up, on a valuation basis, the S&P SmallCap 600 .SML has a forward price-to-earnings ratio of 14.24 percent versus the S&P 500's 11.6 percent .SPX. The Russell 2000 index of small-cap shares .RUT is even higher at 15.74 percent, according to Thomson Reuters data.
While valuations may be high in mid- and small-cap stocks, one fund manager sees the correction as a buying opportunity.
Aram Green, co-portfolio manager of the Legg Mason ClearBridge small-cap growth fund, says cash is piling up on corporate balance sheets while firms go through a digestion phase of assimilating people back into their employment base.
That is perhaps one reason for the lull in hiring, which is feeding into market trepidation.
I think we are going to need more data points, and I think that is why the market is pulling back. They are waiting for that next set of data points, said Green.
I like the stock market here. These are very attractive valuations and if there is any sort of digestion period, we are talking about a minimal impact in terms of the earnings power of these companies over the next 12 months. At very attractive valuations we are putting money to work.
(Editing by Dan Grebler and David Gaffen)