Despite prognostications by market soothsayers that the run for small cap stocks is over, we remain bullish and believe that 2011 economic data and corporate profits will exceed expectations.
Small cap outperformance cycles generally last 5.9 years on average, and we're only two years into this cycle. Despite near-term headwinds like Japan's earthquake disaster and rising oil prices due to Middle East unrest, there are many offsetting positives like rebounding fund flows, robust GDP growth, accelerating M&A activity and, ultimately, the $300 billion repair of northern Japan.
Based on 3-5 percent GDP growth, our expectation for 2011 small cap stock returns is a 10-15 percent range. The average annual small cap return when GDP growth falls in this range is 17 percent in nine prior occurrences dating back to 1932. Based on our recent research, parts of the economy are booming (e.g. industrials). There are still stimulative forces at work, and all signs point to an accelerating, self sustaining economy.
Several positive catalysts underlie today's stock market: fund flows and M&A activity. Despite nearly $100 billion of outflows from domestic equity mutual funds to fixed income and money market instruments over the past two years, the stock market powered higher. We caught a glimpse of a reversal in flows in December when, for the first time in over two years, fund flows into small caps increased by nearly $2 billion. The market surged over seven percent that month.
M&A activity has also accelerated recently and claimed three of our hometown companies- Bucyrus (BUCY), Marshall & Ilsley (MI) and Ladish (LDSH). With nearly $1 trillion sitting on corporate balance sheets and pressure applied by Wall Street for companies to redeploy this under-earning cash, we fully expect an acceleration in M&A activity in 2011. This trend is very bullish for small caps as they are typically acquisition targets.