Time to dump small-caps?

Stocks of all stripes have taken a hiding since the Federal Reserve issued its latest warning about the flagging economy. But smaller stocks, which until recently were looking like world beaters, are taking bigger lumps.

The Russell 2000 index of small stocks is off 6.4% since Tuesday, against a 3.9% loss for the S&P 500.

What’s more, some strategists expect an anemic recovery to keep bleeding small-caps as long as signs of an economic bounceback remain scarce. That could be a while, the way things are going.

“Smaller companies are at a major disadvantage in this environment,” said Andrew Barber, a strategist at Waverly Advisors in Corning, N.Y. “Raising capital in the market, investing overseas, hiring temporary labor – all these factors favor the bigger players.”

That’s not to say buying blue-chip stocks is a walk in the park. Count Hewlett-Packard and Cisco among the deep-pocketed multinationals that have gotten hauled off to the woodshed this month.

But investing in small-cap stocks tends to be costlier, given the thinner markets these stocks trade in. And the high prices currently prevailing on small-cap stocks mean the trade-off isn’t likely to be worth it, BNY Mellon Beta Management said in a study last month.

Using a dividend discount model to project returns, BNY Mellon found small-caps promise no better returns than big-caps for the first time since 1983. It pronounced small stocks “relatively unattractive at this time.”

Barber and Bank of New York aren’t the only ones seeing small-caps as overextended. Value investor Jeremy Grantham mused in his market commentary last month – before the latest selloff — that “both speculative and small stocks that were relatively overpriced on Jan. 1 have beaten the blue chips year to date. It really is remarkable.”

Barber’s firm has been betting since April that big-cap stocks would outperform smaller ones, by buying S&P 500 futures and selling Russell 2000 contracts. He reasoned at the time that the small-cap index “appears overextended from a historical perspective.”

So far, that bet has paid off. Since the April 23 peak, smaller stocks have fallen half again as much as the blue-chips.

Barber says the speculative appetites that drove small-caps higher have been waning, thanks to events such as May’s European debt crisis.

While that problem has been resolved for now, market sentiment remains sensitive to worries about Western economies’ growth prospects and fiscal problems, as well as discrete disasters such as the BP oil spill that fouled the Gulf Coast and the Russian drought that has sent wheat prices soaring.

Not everyone buys the notion that small-cap stocks as a group are overpriced. Buzz Zaino, who runs the $1.7 billion Royce Opportunity fund, contends the 2009 lows left small-cap stocks at “ridiculously low” valuations. He adds that many small-cap stocks remain undervalued even now, after the Russell 2000 nearly doubled off last year’s low.

Even so, he agrees that a nervous market and a weak economy make a rally unlikely for now.

“On average, when people are nervous they will go to the big-caps,” said Zaino.

Zaino says small-caps may find a bid next month when retailers start reporting back-to-school sales. Once the economy starts to show clearer signs of improvement, he says, being invested in small-cap stocks will pay off, because “that’s where most of the money will be made.”

But others counsel patience in waiting for that turn.

“There tend to be periods where small caps outperform, but this does not appear to be one of them,” BNY’s Mark Keleher said.