By Jonathan Burton, CBS.MarketWatch.com
SAN FRANCISCO (CBS.MW) -- Usually when a stock-market recovery gets its legs, investors rotate out of small-cap issues like Krispy Kreme and Sierra Health Services in favor of Wall Street's biggest names, like McDonald's and Pfizer.
Yet two years into what is widely viewed as a textbook economic rebound, large-cap stocks have languished behind their small-cap counterparts.
"We're not seeing a decisive move to large-cap," said Hugh Johnson, chief investment officer at First Albany Capital. "We're seeing some signs of it, but it's not saying to me yet 'jump on board.'"
Even as anemic job growth and terrorism threaten the very existence of the bull market, devotees of the large-cap rotation strategy say the shift to stable, "quality" stocks is long overdue. They assert that shares of large companies -- especially so-called high-quality, well-established names at the top of their industries -- will lead the pack once the broader stock market regains its footing.
"We're seeing opportunities to buy higher quality at lower prices," said Doug Eby, co-manager of the Torray fund /zigman2/quotes/203142581/realtime TORYX +2.37% , which invests mostly in large-cap value stocks.
History sides with the large-cap bulls. Shares in economically sensitive small-cap companies typically surge in the first year of an economic recovery as eager investors grab lower-rated, riskier holdings.
By the second year, as the economy and the market gather steam, so do large-caps. That's what happened in eight of the nine economic recoveries since 1949, according to Ibbotson Associates, the Chicago-based research firm.
Many economists regard November 2001 as the endpoint of the last downturn, so 2003 should have been large caps' turn to shine. It wasn't. The Standard & Poor's 500 returned almost 29 percent last year, but the S&P Small Cap 600 gained 39 percent.
Performance-chasing latecomers may be likely culprits for small-caps' extended streak, but some observers notice a change in perception at work too. "It's no longer compelling to buy small companies," said First Albany's Johnson. "They're just not that cheap anymore."
Moreover, market volatility is sapping investor enthusiasm for small-company shares, which typically are riskier bets. Money is heading to small-cap funds at a slower pace this year than in the last three months of 2003, while the exodus of capital out of large-stock funds is subsiding, according to TrimTabs.com, which tracks asset flows at many large fund firms.
"Last year, investors were rewarded for taking risk," said Bill Nygren, manager of the Oakmark fund /zigman2/quotes/203815081/realtime OAKMX +2.70% , which focuses on large-cap value stocks. "The way to have made the most money in 2003 was to only buy stocks that lose money or don't pay a dividend. That's probably not a winning strategy long-term."
Indeed, market professionals say, the year is unfolding as one where high-quality stocks outdo low-quality shares, a trend favoring many established large-cap issues.
Stocks that got a top-notch rating from S&P topped lower-quality shares by 4.5 percentage points in February -- their strongest monthly outperformance since December 2002, according to Merrill Lynch.
In addition, high-quality or better-rated shares in 6 of 10 S&P industry sectors outperformed in February, the broadest showing in a year.