When searching for opportunities to reap big returns amid a market slump, it pays to think small.

That's what fund-tracking firm Lipper had to say about comparing the performance of large-cap mutual funds to small-cap mutual funds. In the last four-plus years, from January 2000 through the first quarter of 2004, small-cap stocks have substantially outperformed large-cap stocks, according to a recent research report Lipper released last week.

"Normally, coming out of economic recessions, in the first 12 to 18 months of a stock market recovery, you'll see small-caps and mid-caps beating large-caps," said Andrew Clark, senior research analyst at Lipper. "The reason for this is that small- and mid-caps tend to be more domestically focused firms that aren't drawing a lot of earning from overseas for the most part."

Indeed, $100 invested in the S&P small-cap stock index at the end of 1999 was worth almost $150 as of March 31, while $100 invested in the broader S&P 500 was worth $81, the report revealed. The small-cap index earned nearly $70 more than the large-cap index, a comparison that did not occur in one fell swoop. In fact, over the course of much of the recent bear market, small-cap stocks rarely ventured below the initial $100 investment level. However, large-cap stocks were consistently worth less than the initial investment.

This is somewhat of an anomaly because over a longer time period, large-cap stocks have far outpaced their smaller-cap counterparts. Lipper noted that if $100 had been invested in the S&P small-cap index in October 1994 and $100 had been invested in the S&P 500 on the same day, for most of the 90's, the S&P 500 would have generated a greater return on a cumulative basis. But at the end of March 2004, the small-cap stock investment was worth $324, while the large-cap investment was worth $307.

Underpinning the recent surge in small-cap stocks were robust gains in three economic sectors including electronic technology, industrial services and finance. Breaking down the numbers, when small-cap electronic technology exceeded large-cap electronic technology, small-cap funds beat large-cap funds 75% or more of the time on a weekly, monthly or quarterly basis.

Another key finding was that when small-cap electronic technology and small-cap industrial services surpassed their large-cap counterparts during all three time frames, small-cap funds beat large-cap 87% or more of the time. Lastly, when all three small-cap sectors beat their large-cap brethren on a weekly, monthly or quarterly basis, small-cap funds exceeded large-cap funds in every case.

Lipper used technical analysis tools, particularly relative strength, to signal turning points in the bout between the small-cap and large-cap genres. The firm concluded that using these tools on quarterly or yearly price data was a good way of deciding in which direction one should allocate between small-cap and large-cap funds. The most accurate measure in terms of generating the steadiest signals, was the use of quarterly data, the report said.

"Once it looks like the economy has some legs, then there tends to be a switch, albeit a slow one, from small-cap and mid-cap into large," Clark said. "If you start to see the large-cap electronic technology sector begin to consistently go past the small-cap one, that's probably a sign there's been a shift in performance." He said that would be confirmed by what happens in industrial services as well.

Clark further noted that people have been saying for nearly a year that large-caps are going to move past small-caps, but that still hasn't happened. When the bigger electronic technology and industrial services firms pull ahead of the smaller ones, it's a sign that the market players believe the economy has enough strength to go forward.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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