Big worries about small stocks

Investors looking for clues about the market's direction look to small-company stocks for cues. And it's not a pretty picture.

The Russell 2000 index of shares of small companies slipped 1.2% during July - trailing the 2% gain by the predominately large-company based Standard & Poor's 500. The Russell 2000 has been stuck in a trading range all year as small companies' shares are punished by "questions surrounding global growth due to China, the meltdown in commmodities and a bit more choppiness in the market," says Steven DeSanctis, analyst at Bank of America Merrill Lynch in a note to clients.

Small caps are the epicenter of concern for investors - profit growth isn't good enough to justify the prices on stocks. The Russell 2000 trades at a lofty price-to-earnings of 19 on expected earnings, DeSanctis says. Trends within small-company stocks are concerning. The best sector pulled ahead of the worst one by 22% and small growth stocks are climbing past value priced ones by the biggest margin since 2007. Much of the runup by small growth stocks is due to the strong performance of biotechs - which is concerning in itself, DeSanctis says. "We think biotech could be headed toward Bubble status and we could be selective in this group," DeSanctis says. Small caps are also at risk to the whims of the Federal Reserve. "Volatility should pick up with the uncertainty surrounding the Fed rate decision in September and when volatility rises, risk assets like small caps tend to lag behind," he says.

Paste BN markets reporter Matt Krantz answers a different reader question every weekday. To submit a question, e-mail Matt at mkrantz@usatoday.com or on Twitter @mattkrantz.