The Globe and Mail

If we had to bestow a name on the stock market rally of the past four months, we might go with something like Small Miracles. Or maybe Tiny Dancers.

That’s because this rally – unlike in earlier stages of the market’s recovery – has been utterly dominated by small-capitalization equities, which are running away from their larger-cap counterparts, as improving U.S. economic data and new easy-money Federal Reserve Board monetary policies spur a renewed appetite for stocks. The small-cap Russell 2000 index has jumped almost 30 per cent since the beginning of September, crushing the S&P 500 by almost 10 percentage points.

The easy answer for this might be that investors have been busily unwinding risk they had heaped on equities amid the economic uncertainty of earlier in the year – and the riskiest stocks and those most sensitive to economic growth, namely the little guys, are benefiting disproportionately from the change in mood.

But while that may be partially true, it’s far from the whole story. In fact, the small caps are earning their outperformance – and may well continue to do so in 2011, says UBS Securities.

Bigger Surprises, Smaller Margins

UBS’s global equity strategy team said in a recent research report that upside earnings surprises among small-cap stocks have been outpacing large-cap surprises in recent quarters, as analysts have been gradually adjusting their expectations for large-cap earnings yet continue to underestimate growth potential in the small-cap segment. Similarly, on revenue growth, the Street has had a very good handle on large-cap numbers this year, but small caps continue to exceed expectations.

Yet profit margins for small-cap stocks are drastically lagging those of large caps. Large-cap margins snapped back quickly after the downturn and are already back to their pre-recession peaks, UBS noted, while small-cap profit margins are still well below their peaks. The gap between large- and small-cap margins is near a record high, UBS said.

This leaves small-cap margins with more room to grow relative to their large-cap peers, a bullish sign for small-cap stocks.

“This should lead to bigger quarterly beats and faster upward earnings revisions in the small-cap universe,” UBS said.

A Little Glimpse at 2011

“In 2011, we expect the economic recovery to remain on track and upside earnings surprises to continue. While lingering macro concerns may cause episodic spikes in volatility, risk appetites should generally increase over the course of the year,” the UBS team wrote.

“All of this supports a continued rotation into riskier assets generally, and small caps in particular.”