Small-capitalization stocks are known for their volatility compared to the broader stock market.

When investors are optimistic about the economy, they tend to invest in small-cap stocks to take advantage of quicker returns on the way up.

Despite the fact small-cap stocks have tumbled recently as greater economic uncertainty increased, the average domestic small cap mutual fund in Standard & Poor’s MarketScope Advisor database outperformed the overall equity category year to date through July 9, according to a report by S&P Mutual fund analyst Todd Rosenbluth.

Small-cap value funds increased 2.09% year-over-year through July 9, according to Rosenbluth, while mid-cap value funds rose 1.21% and large-cap value funds declined 2.88%.

Meanwhile, small-cap core funds¸ which include a mixture of growth and value stocks, increased 1.15%, while mid-cap core funds rose 0.93% and large-cap core funds decreased 3.68%.

Year to date through July 9, small-cap growth mutual funds have performed well, with total return of 0.6%, compared to the 1.7% loss in the S&P domestic equity mutual fund category (including funds focused on various styles and market caps) and the S&P 500 Index's 3.3% decrease.

These figures indicate strong performance by the small cap sector over all other fund sizes year-to-date and versus the S&P 500 Index. Yet as of June, Rosenbluth reported that small cap funds have gotten riskier.

In early July, S&P's Investment Policy Committee lowered its overall recommended exposure to U.S. equities to 40% from a previous 45%, and raised its allocation to bonds to 30% from 25%, citing high volatility, due global growth concerns and fears over sovereign debt.

At the bottom of the bear market in November and December 2008 into early March of 2009, large cap stocks kept declining while small cap stocks remained steady, said Ralph Fogel, the head of investment strategy at Fogel Neale Partners, in an interview.

“This is how we knew we were at a bottom,” he said. “When the new lows became less frequent it was an indicator that markets were gaining momentum.”

Then last year, the small cap stocks outperformed tremendously. That is because investors knew they wanted to make up for the losses of 2008 and small cap stocks would make money faster since there were less shares outstanding.

But from January through May, the market went sideways, Fogel said, and small caps outperformed larger stocks, but not as much as they did in 2009. Finally from May 28 through July 6, the decline in small cap stocks were in lockstep with the Dow Jones Industrial Average and the S&P, he said.

“In 2009 it looked like we may be going into an economic recovery and during this period of time with this snap back rally in 2009 and in the beginning of 2010 investors wanted to make money fast,” Fogel said. “Now from January through May of 2010 the reality sets in. Large companies are better equipped to deal with difficult times than small companies because they have more capital and more wherewithal to be able to deal with the downturn so the Russell 2000 Index fell 20% from May 28 through July 6, while the Dow only fell 14%.”

What does this mean?

It means investors think the economy will get worse, not better, Fogel said. “In a difficult and deteriorating economic time you want your money in a company that has more money and that you believe will survive,” he said.

Whereas in 2009 investors felt optimistic about the country’s economic future, now the pessimism has set in.

“In my opinion small caps are not going to continue to outperform,” he said. “I don’t see great upward thrust for the stock market. I think there is more risk than reward out there and I think the market is telling us the economy won’t get a good deal of growth in the next six to nine months from now.

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