Underperforming money managers are losing their most reliable scapegoat.
Since the 2008 financial crisis, the nation's professional stock-pickers _ who manage billions for pension funds, endowments and wealthy families _ have said stocks were too stuck-together to build smart, market-beating portfolios.
When stocks are rising and falling in unison based on the same big-picture economic news, with little regard for the companies behind them, it's tough to beat the market.
That's no longer a problem for the 2,000 relatively small companies in the Russell 2000 index. Correlation among Russell 2000 stocks, as measured by data analysts at Credit Suisse, plunged to 20 percent in late January, from 74 percent in September.
Meanwhile, the Russell has been on a historic upswing, gaining more than 36 percent in the past four months, compared with 22 percent for the much-bigger companies in the Standard & Poor's 500 index.
Last month, the mighty Russell rose 7 percent _ 60 percent better than the S&P 500, and its strongest January since 2006. The median market value of a Russell 2000 company is $563 million _ about one-twentieth the median size of S&P 500 companies.
It should be a small-stock-picker's paradise. Yet only 42 percent of the small-cap funds tracked by Credit Suisse are beating the market so far this year, compared with half of S&P 500 funds.
"This should have been a period when stock-pickers should have done well, and unfortunately, it just didn't happen," says Lori Calvasina, the lead author of the Credit Suisse report. "It does feel like this was an opportunity that got missed."
So how did so many fund managers end up holding the wrong stocks? They were too cautious, Calvasina says.
Late last year, many were afraid that Europe's debt crisis would boil over, threatening the U.S.'s slow economic recovery. They set about buying "high-quality" stocks _ bigger companies, often in industries that do well when the economy is weak. Traders also bid up stocks of companies that do most of their business here in the U.S., Calvasina says.
Those aren't the stocks driving the Russell index's gains. As the economic outlook has improved this winter and traders have grown less worried about Europe, stocks have gained the most in sectors that are sensitive to the economy, such as homebuilders, boatmakers and furniture manufacturers.
"Plain and simple, (fund managers are) just not positioned for this," Calvasina says. "The portfolios that most small-cap fund managers have built are positioned to outperform in pullbacks, not to dominate in rallies."
One investment adviser who gave in to last fall's economic worries is Don Olmstead, managing director of Novare Capital in Charlotte, N.C. Olmstead sold his clients' small-cap stocks in September because the market was volatile and it looked like a financial shock from Europe might push the U.S. into a double-dip recession.
"If we were going into a slower-growth type of an economy, small-cap was not a place to be in our clients' portfolios," says Olmstead, whose company invests about $500 million on behalf of families, trusts, foundations and corporations.
Olmstead's was the correct call for many investors. Small-company stocks are inherently risky, and they fall faster when the economy hits a snag. Even when his company is confident enough to endorse small-cap stocks, Olmstead says, portfolio managers still assess whether they're a smart choice for a given client's account.
Investors seeking a little more risk in their financial lives still have time to join the small-cap rally, says Sam Stovall, chief equity strategist at S&P's Capital IQ, a data and research company.
One reason: Russell 2000 stocks fell further during last year's selloff, so they have further to climb. The Russell 2000 skidded 30 percent between its April 29 high and its Oct. 3 low last year, compared with 19 percent for the S&P 500 and 17 percent for the Dow Jones industrial average.
After last year's losses, investors should ask what investments typically do well in the first year of a new bull market, Stovall says. "The answer is, stocks over bonds, small-caps over large-caps," he says.
Stovall said last year's sell-off amounted to a "mini-bear market" because the major indexes declined less than the 20 percent typically that defines a bear market. The market has experienced eight such baby-bear corrections since World War II. Each time, stocks were sharply higher three, six and 12 months later.
"For four months of pain, you get an average of 12 months of pleasure, and right now, we're four months into the 12," Stovall says.
But this year's small-cap gains aren't merely a normal rebound from last year's overselling, says Doug Roberts, chief investment strategist with Channel Capital Research. He says they're also a result of the Federal Reserve's policy of keeping short-term interest rates near zero.
Smaller companies generally have more trouble borrowing than their bigger counterparts, Roberts explains. But when the Fed is using all of its tools to spur growth, as it has during this recovery, they can borrow more cheaply. That increases their chances of success, Roberts says.
"It's the cheap money, or the liquidity, that drives up stock prices," he says.
To beat broader indexes, analysts say, it's worth focusing on companies' fundamental strengths _ especially as correlations break down and companies' financial results retake center stage.
Stovall says investors should focus on sectors that do well during periods of growth and select companies with strong analyst ratings and high price targets.
Calvasina says small-cap pickers should chase "low-quality" bets _ tiny companies with low return on equity, negative earnings and low expectations among Wall Street analysts. That's a lot easier for fund managers, who typically have access to much better company information than individual investors.
Companies that suffered from economic fears, such as homebuilders and shippers, have been outperforming and surprising investors. Their stock prices are jumping.
Take The Ryland Group Inc., a homebuilder in Westlake Village, Calif., with a market value of about $902 million. The stock has more than doubled since October's low, despite its having lost money in each of the seven previous quarters. Ryland eked out a profit of 2 cents per share profit in the quarter ended Dec. 31, it said last week.
John Fox, director of research at Fenimore Asset Management in New York state, says traders should look for companies that aren't already picked-over by Wall Street analysts.
"In small-cap world, you have many more stocks to pick from, and you can find companies that may have one analyst looking at them, or no analyst coverage at all," he says. "That's what's different."
Follow Daniel Wagner at www.twitter.com/wagnerreports.