NEW YORK (Reuters) - U.S. small-cap stocks, which have been lagging behind their large-cap brethren, may be poised to take the lead if the nation's economy continues to show modest growth and the dollar maintains its ascent.
The S&P 500 stock index .SPX has rallied nearly 13 percent from its Aug. 25 low, while the small-cap Russell 2000 has advanced just 7.5 percent in that time.
The larger names have benefited from a dovish statement from the U.S. Federal Reserve in September, easing concerns about a slowdown in China's economy and an earnings season that has been less bad than feared.
But with the dollar likely to strengthen in light of the Fed's latest statement in October, which put a year-end rate hike back on the table, and expected stimulus measures from other major central banks, small-caps may have more room to run higher as their earnings are less likely to take a currency hit.
"Small-caps will probably take a little bit of the driver's seat again, mostly due to the fact that a stronger dollar clearly benefits them," said Omar Aguilar, chief investment officer of equities at Charles Schwab Investment Management in San Francisco. "Their balance sheets are pretty strong, and they have a little cash."
Furthermore, the small-caps remain somewhat low priced, based on the earnings they expect over the next 12 months. The Russell 2000's forward price-to-earnings ratio has fallen below 23, roughly where it was at the August lows. In April, it was above 26.
To be sure, any move up in small-cap stocks may not be rocket-like, according to a reading of technical indicators that show that the index will need to overcome obstacles in the form of its September high and 200-day moving average. Also, the same headwinds that may affect larger companies may also hurt some Russell components.
One way to steer through the group and take advantage of this economy is to focus on small stocks with a regional focus, said Eric Marshall, director of research at Hodges Capital Management in Dallas. He suggested avoiding energy companies and those with big international exposure.
Marshall likes names such as U.S. Concrete (USCR.O) and Summit Materials (SUM.N), which are unlikely to face competition from cheaper imports, have high barriers to entry and could get a boost from government infrastructure projects such as a new highway bill.
"There are situations where you can find companies that are posting record earnings," he said. "(These) stocks are moving up hitting new highs, and they are really not sensitive to what is going on in China."
Additional reporting by Lewis Krauskopf; editing by Linda Stern and Lisa Von Ahn