Russell 2000 Tops S&P 500 for Fourth Month on Dollar, Bank Gain

By Lynn Thomasson

Sept. 2 (Bloomberg) -- Small-cap stocks beat the Standard & Poor's 500 Index for a fourth month, the longest streak since 2003, after the rising dollar boosted demand for companies with the least international sales and financial shares rebounded.

The Russell 2000 Index's 3.5 percent gain outpaced the 1.2 percent increase in the S&P 500 because smaller companies get 81 percent of their revenue from the American economy, compared with 67 percent for larger businesses, according to Merrill Lynch & Co. The concentration on domestic sales makes small-caps less vulnerable to a strengthening U.S. currency, according to James Investment Research and ING Investment Management.

While rising exports helped the U.S. economy expand 3.3 percent in the second quarter, shrinking economies in Europe and Japan are threatening overseas sales. The dollar's 9.8 percent rise from its July 15 record low against the euro also reduces gains from currency translations.

``Growth is falling off a cliff in Asia and parts of Europe,'' said Brian Gendreau, a New York-based investment strategist at ING Investment Management's asset-allocation business, which oversees $18 billion. ``The wind has come out of the sails for large-caps.''

The August gains for the Russell 2000, whose companies have a median market value of $505.7 million, reduced its decline this year to 3.5 percent. The S&P 500, whose average value is $11 billion, fell 13 percent. Ambac Financial Group Inc. and Radian Group Inc., which were added to the Russell 2000 in June after losing more than 90 percent in New York Stock Exchange trading, led the advance.

Fund Flows

The Russell 2000 last outperformed for four straight months in 2003. The index rose 45 percent that year for the biggest rally in its 29-year history.

Exchange-traded funds that own smaller companies attracted a net $809 million in May, while funds holding larger firms saw a $2.4 billion outflow, according to Birinyi Associates Inc., a Westport, Connecticut-based research provider and money manager.

For the year, investors pulled $4.6 billion from large-cap funds, almost twice as much as they withdrew from small-caps, based on overall assets, Birinyi's data show.

Exports boosted U.S. economic growth in the second quarter, narrowing the trade deficit to the smallest in eight years. Countries sharing the euro contracted 0.2 percent last quarter, while Japan declined 2.4 percent, signaling demand for U.S. exports may wane, according to data compiled by Bloomberg.

``Small-caps will be a better place to be,'' said Barry James, who oversees $2 billion as president of Xenia, Ohio-based James Investment Research. ``Folks are shifting to more home- grown companies than international'' as the dollar weakens, he said.

`Meaningless' Advantage

The advantage won't last, according to Merrill Lynch's small-cap strategist Steven DeSanctis. His research found the link between the dollar and relative performance in large- and small-cap stocks ``meaningless,'' according to an Aug. 25 report.

``We do not think that investors need to hang their hats on this variable as a predictor of small-cap outperformance,'' New York-based DeSanctis wrote.

Banks, brokerages and insurers in the Russell 2000 fell 3.9 percent since April as subprime-related losses at the biggest financial companies topped $512 billion. Russell 2000 banks outperformed those in the S&P 500 by 16 percentage points.

Earnings in the first and second quarters declined 56 percent and 50 percent on average for Russell 2000 financial companies, according to data compiled by Bloomberg. That compares with of 83 percent and 91 percent for the S&P 500 group.

Blackbox Penalties

``The balance sheets of small-cap financials are much less mysterious and complex and blackbox-like when compared to their large-cap counterparts,'' said Lawrence Creatura, who helps manage $2.7 billion at Clover Capital Management Inc. in Rochester, New York. ``Large-cap stocks are getting penalized.''

Russell Investment Group, based in Tacoma, Washington, added New York-based Ambac and Philadelphia-based Radian to its U.S. small-cap benchmark in June after their shares tumbled because of credit-market losses. The stocks more than doubled in since July 7, when the Russell 2000 hit a four-month low.

To contact the reporter on this story: Lynn Thomasson in New York at lthomasson@bloomberg.net.