On Jan. 17, small-company stocks fell into a bear market, defined as a drop of 20 percent or more from a recent peak. They have since rallied...

Share story

On Jan. 17, small-company stocks fell into a bear market, defined as a drop of 20 percent or more from a recent peak. They have since rallied along with the broader market, but the gains may not last if there’s a recession.

Citi Investment Research analyst Lori Calvasina, in a client note, writes that small-company stocks — ones with market capitalizations less than $2 billion — have lost as much as 32 percent at their troughs during recessions. Citi thinks the economy is in a recession.

Historically, small stocks have outpaced large stocks. But in economic downturns, investors generally prefer big companies with revenue that is diversified globally and by customer base. Most small companies rely more on U.S. demand than large companies.

Among small-cap sectors, health care, consumer staples and financials tend to perform well in the early stages of a recession, Calvasina says. She rates these sectors “overweight.” Small-cap financials are less exposed to risky mortgage-backed securities than their bigger brethren and have generally avoided big write-offs.

Her favorite defensive picks are Omrix Biopharmaceuticals (OMRI), Spectranetics (SPNC), Waste Connections (WCN), Wisconsin Energy Corp. (WEC) and Time Warner Telecom (TWTC). Calvasina says to avoid small-cap materials, technology and capital-goods stocks, which tend to perform poorly early in a recession.

Historically, small-cap stocks have gained an average of 38 percent as the market and economy recover, she writes.

“In many respects, small-cap performance during a recession is very much like pulling back on a slingshot or a rubber band — the most important question is not whether the recovery will be powerful, but the timing of the release,” she writes.

She says small caps could rally well before December, ending a rocky 2008 with a low single-digit percentage loss if the recession doesn’t last much more than a year, as Citi economists expect.