INVESTING: Big caps are back and best place for big 2007 gains

As this rally labors on, one point I brought up a few times in January is becoming clear. I expected that the small-cap stocks, which put on a powerful era of outperformance from 1999 until 2006, would cede their leadership to the bigger companies in America. A seven-year cycle of better returns is typical of the smaller stocks, and that ended last May. For the rest of 2006, things were about equal, and now the evidence is staring us right in the face: The age of the big caps has returned.

Knowledge brings responsibility and in this case that duty lies with ensuring your portfolio is correctly positioned for this change. For 2005 and more so in 2006, investors chased the returns of small-cap stocks and foreign offerings. And as usual, just when they bought all they could handle, the market changes.

Here’s an example: In 2005, the Russell Small Cap index, which is a basket of stocks with market values of $150 million to a little over $1 billion, went up about 7-1/2 percent, versus a gain of 5 percent for the S&P 500 (including dividends). The performance was roughly the same last year. And so far in 2007, the S&P 500 is beating the Russell 2000 by 1-1/2 percent. Over the last three months, the change is even greater, with the S&P beating the Russell by 2 percent.

The larger stocks’ pace of outperformance seems to be accelerating this year. The nearheroic performance of the Dow Jones industrial average since the March low is the glaring sign, but the not-much-talked-about rise of stocks like Microsoft is the subtle clue.

Financial analysts and advisers strongly believe the United States is slowing this year, and that the longer-term prospects pale in comparison to Asian growth opportunities. I agree with those sentiments, but if you want to make great money in the stock market this year, you have to downplay that advice. For reasons that currently escape my logic, big American stocks have been and will continue to be the place for the best gains in 2007. And as I’ve learned over the years, it usually doesn’t make sense until after the fact.

Reducing your expectations for smaller stocks doesn’t mean bailing on the market altogether. The main idea here is that most of the stock market still is healthy, and higher prices are expected over the next four to six months, at least. But micro and small-cap stocks should move up less than their larger brothers. If the Dow Jones industrial average is up another 10 percent between now and the end of the year, the Russell 2000 may be up only another 3 percent or 4 percent.

On a shorter-term basis, the market might have entered a phase of consolidation/correction. Corrections of 5 percent or even 10 percent often are a necessary step on the way to a more sustainable uptrend. The stuff to try to buy the dip on are the same sectors that have worked so well in the past few years: utilities, materials, energy and consumer non-cyclical. You can add health care now that it has proved itself for more than just a few months. And selective large-cap technology.

Wouldn’t it be something if Microsoft hit a new all-time high before this bull market ends? It could happen.