Small-Cap ETFs: Where The Rally May Be Going

Small U.S. stocks and related exchange traded funds (ETFs) have outstripped the performance of  others in the marketplace, but the fast pace may not last, according to some.

Since the March lows, small-cap U.S. stocks have gained 70% on average , but analysts warned that small stocks may begin to slow down, citing a deeply scarred economy, restrictive bank lending and high small-cap stock valuations, reports Sam Mamudi for MarketWatch.

One skeptical Lipper senior analyst, Tom Roseen, says that the continuing steep climb in small-cap shares is justifiable if profitability is there. Sam Dedio, manager of Artio US Smallcap Fund, has pointed out that a lot of the bailout money has not been given to small-cap financials and this would prolong the crisis for these smaller companies.

One factor that may hold back small-caps is valuations. Since 1995, the median PE ratio of large-caps is 20.7 whereas small-caps is. 24.6%. Today, average PE ratios of small-cap stocks is around 18 times 2010 earnings estimates while large-caps are around 14 times next year’s estimates, which shows that larger stocks have a greater upside potential.

Some experts remain optimistic about small-caps, pointing to historical references that showed small-caps to greatly outperform mid- and large-caps.  Furthermore, analysts believe year-over-year small-cap earnings will jump 86% on average, compared to a 34% rise for large-caps.

Before jumping into any investment or ETF, be sure to watch the trend lines. We utilize the 200-day moving average to determine our course of action.

• Vanguard Small Cap Value ETF (VBR): up 16.4% year-to-date

• PowerShares Dynamic Small Cap (PJM): up 5.3% year-to-date

• SPDR Dow Jones Small Cap Value (DSV): up 23.4% year-to-date

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