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Small caps' star may have peaked in 2013

It's been a fantastic time for stocks, but it's been even better for shares of small companies like Zale Corp.

The small Texas company's shares rocketed more than 280 percent last year, propelled by investors who expect lovebirds to increasingly shell out big bucks for gold rings and diamond-encrusted pendants at Zale's jewelry stores and shopping center kiosks around the country.

Investors have piled into Zale despite the company's shaky earnings history — it posted four straight years of losses before returning to profitability in 2013. It's a risk optimistic investors have been willing to take, betting that small-cap companies will continue to lead the market higher.

"They've done extremely well," said Ed Zschau, 49, who runs an executive search firm in the San Francisco Bay Area and invests in mutual funds focused on small caps as well as young tech startups. "There's a lot of these companies that have, I think, still a lot of room for growth."

Small caps, defined generally as companies valued at less than $2 billion, tend to lead the way during stock market rallies. Their shares often outshine those of larger, more mature businesses with stronger earnings track records.

The current bull market has been no exception. While the benchmark Standard & Poor's 500 index shot up 30 percent last year, the S&P SmallCap 600 index vaulted about 40 percent.

It's a continuation of a trend since the market's recent nadir following the 2008 financial crisis. The S&P 500 is up more than 140 percent in the bull market that started in 2009, while the small-cap index is up 220 percent.

"The small-cap market has been on a complete tear," said Chuck Myers, a portfolio manager at Fidelity Investments in Boston.

Investors shoveled about $15 billion into small-cap mutual funds through November last year, according to data provided by Morningstar Inc.

And anybody who sank money into those funds has been especially rewarded, reaping more than a 30 percent return last year, the data show. Some of the largest such funds include the Vanguard Small-Cap Index Fund, the T. Rowe Price New Horizons Fund and the Fidelity Small Cap Discovery Fund.

Those types of returns are what investors have been chasing, thanks largely to the easy-money policies of the Federal Reserve.

The Fed has been pumping $85 billion a month into the economy by buying long-term Treasury and mortgage-backed securities. The goal has been to push down interest rates as a way to stimulate growth by making borrowing cheaper for consumers and businesses.

But the Fed's program, known as quantitative easing, has nudged investors out of traditionally safer investments such as top-rated corporate or government bonds and savings accounts. To get any meaningful return, investors have plowed into riskier assets such as stocks.

And among equities, small caps are a bigger gamble.

"Generally this is a risky asset, and, like a lot of risky assets, the riskier ones tend to do better when people are in a very, very aggressive mode," said Russ Koesterich, global chief investment strategist at the financial giant BlackRock Inc.

It's not just small companies' stock prices that the Fed's policies have lifted.

With interest rates near historic highs, investors chasing yield poured into companies that pay a premium to borrow.

Bonds issued by companies whose debt carries a non-investment-grade, or "junk," rating have been some of the most sought-after investments as the Fed kept a lid on interest rates.

In 2012, high-yield bond funds took in $25 billion, returning 15 percent for investors, according to Morningstar. (Last year, however, the inflows slowed as the Fed contemplated tapering its stimulus: Those bond funds took in $3 billion through November, returning only 7 percent. And this month, the Fed's tapering is due to begin.)

With rates low and investors clamoring for such higher-yielding bonds, many smaller companies were able to significantly reduce their debt-service costs by refinancing.

Those savings boost bottom lines, which ultimately help the companies shine on Wall Street.

"There has been such demand for high-yield — this quest for yield — that junky companies are able to refinance their debt because there is a huge demand for it, and they get a huge improvement in earnings, and then their stocks react quite well," said Bernie Williams, chief investment officer of USAA Investment Solutions.

But the sharp run-up in small-cap stock prices has made them relatively expensive, leading some market experts to worry that the sector is getting overheated.

One commonly used measure of value indicates small-cap mutual funds are costing investors more than mutual funds focused on larger companies.

The price-to-earnings ratio for small-cap funds was 21.22 near the end of last year, compared with 18.42 for large-cap funds, according to Morningstar data based on earnings in the past 12 months. The difference between the P/E ratios has been steadily growing since March.

Brian Overby, a senior options analyst at the online brokerage TradeKing, said small companies' stocks would depend on domestic growth.

"If you believe the U.S. economy is going to bounce back and have a better year than you did last year, then small caps (are) a good spot to be," he said.

Some in the market aren't as impressed.

"It's overheated," said Jack Ablin, chief investment officer at BMO Private Bank. "These are stock prices that earnings can never meet."

And there are signs that investors are cooling on small-cap stocks. The S&P 600 lagged behind the broader S&P 500 in December.

Whether this spells trouble for the broader market is unclear. Small caps can lead the stock market on the way down too.

Either way, few expect small caps to deliver anywhere near the same returns in 2014.

"One should certainly not expect the returns of the last 41/2 years in the next 41/2 years," Fidelity's Myers said.