Defying market logic, small-cap funds ride the strong dollar to beat large caps

The powerful run by small-cap sector stocks so far this year has upended traditional market logic, giving some investors a reason to believe the long bull market still has room to run. Smaller-company stocks, which typically lead the way out of a market downturn, are suddenly the hottest category more than six years after the market's 2009 bottom. Small-cap growth mutual funds, as tracked by Morningstar Inc., have gained 7.7% since the start of the year, and the category is up 14.1% over the past 12 months.

Source: Morningstar Inc.

That compares with a 6.9% gain this year for mid-cap growth funds, which are up 12.7% over the past 12 months. Large-cap growth funds, which traditionally lead the way toward the end of a bull market cycle, have gained 5.2% so far this year, and are up 12.3% over the past 12 months. “I have put my eggs in the small-cap basket over the Dow and S&P 500,” said Paul Schatz, president of Heritage Capital. Mr. Schatz is attributing the strong run by small-cap stocks to the surging strength of the U.S. dollar, which tends to hurt larger multi-national companies that derive more revenue from non-U.S. sales. Smaller companies are generally better insulated from global currency fluctuations because they do a higher percentage of business inside U.S. borders. According to Jonathan Golub, managing director at RBC Capital Markets, large-cap companies, on average, do more than a third of their sales outside the U.S., compared with about 17% for small-cap companies. While Mr. Golub recognizes the impact of the strong dollar on corporate earnings, he added that there are other factors that also favor smaller companies. “At this point, small caps are delivering faster revenue growth, and the market is rewarding fundamentals,” he said. 'SOMETHING VERY STRANGE' But “there is something very strange happening in this cycle right now,” he said. “Coming out of a financial-driven crisis, a lot of smaller companies lost access to financing, so their business models were under a lot of pressure, while the larger companies that were in better shape were able to get financing to grow.” In addition, small-cap stocks are coming off a rough 2014, when the category gained just 2.5%. The small-cap growth story over the past several months has been in stark contrast to small-cap value funds, which gained 10% last year, and are up just 2.8% this year. “Small cap growth is showing better relative strength, especially when compared to the S&P 500 and the Dow over last three months,” said Edward Gjertsen, vice president at Mack Investment Securities and president of the Financial Planning Association. The disparity between value and growth, he added, makes the case for diversification. “Just throw yourself into a blended portfolio and you'll be OK,” he said. “But sometimes, chasing the latest performance is something we struggle with as a profession.” Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, acknowledged “it's not normal for small-cap stocks to lead this late in the bull market cycle.” “Normally, at this point, we see more choppiness and the bull gets tired, and large caps tend to be a good safe haven investment,” he said. “The strong dollar is definitely playing a role this year,” he said. “But you also have factors such as the strength of the health care sector, which is going to have a larger weighting among smaller-cap funds.” HEALTH CARE LEADING THE PACK Among the sector-fund categories, health care is well ahead of the pack, with a 14.8% gain this year, and a 12-month gain of 36.2%. Technology, the next-best performing sector, has gained half as much over the same periods. Even if the small-cap run is somehow out of sync with historical market cycles, there is still a reason to rely on logic for navigation purposes, according to Mr. Schatz. For starters, he said, the mega-cap multinational companies will adapt and the small-cap currency advantage will eventually dissipate. “Even if the dollar rally continues for five years, it doesn't mean small caps will continue to lead,” he said. “But the best part is, small-cap leadership is very bullish in the intermediate term for the U.S. market, because this type of leadership typically doesn't happen at the end of the bull market.”