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Small cap, big hurdle Add to ...

If you believe in the January effect -- stock gains in January bode well for the rest of the year -- then you may be feeling a bullish twinge these days, after the Dow Jones industrial average turned in its best performance for the month since 1997. However, small-cap stocks are pointing in a different direction: The small-cap Russell 2000 index fell 0.3 per cent last month.

According to Steven DeSanctis, small-cap strategist at Merrill Lynch, this bodes poorly for small-cap stocks in 2011 -- especially given the headwinds they face. In particular, valuations look stretched based on estimated price-to-earnings ratios. This, of course, comes after a stellar year in 2010, when the Russell 2000 rose 27 per cent, against an 11 per cent gain for the large-cap Dow.

"Estimates are too high in our opinion and have not fallen as rapidly as we would like to see," Mr. DeSanctis said in a note.

His conclusion: "The rally in small caps stalled a bit last month and we saw a rotation back to large caps not just in terms of performance but also fund flows. When small does not beat large in January, performance for the full year comes in below average and small caps have a less than 50 per cent chance of outperforming large caps."

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