Will small stocks ever slow down?

(Money Magazine) -- When it comes to investing in small companies, there are usually a couple of things you can be sure of.

For starters, fast-growing but less established firms often shine in the early stages of a rally, as Money noted back in June 2009.

And true to form, small-capitalization stocks rocketed about 100% in the first 12 months of this bull market. But shares of smaller firms -- with stock market values of $2 billion or less -- are also more prone to fall in a financial panic than big, blue-chip stocks.

Yet throughout most of this year, when the European debt crisis sent jitters throughout the global markets, small-caps kept plugging along. They hit a big speed bump in May, as did most equities. But so far in 2010, when foreign shares have sunk and the S&P 500 up just 1.6%, small stocks are still up nearly 6%.

Some of this may be due to fundamental factors. For instance, small firms moved aggressively to slash costs during the downturn and greatly improved their bottom lines.

But the market may also be favoring stocks that aren't perceived to be exposed to Europe's financial woes. Small companies are generally less tied to the global economy than are big, U.S.-based conglomerates.

Indeed, while 14% of revenue generated by companies in the S&P 500 index comes from Europe, only about 4% of small-company sales derive from that region, according to Howard Silverblatt, senior index analyst at Standard & Poor's.

This may help explain why small companies are forecast to enjoy profit growth of more than 133% in 2010 -- more than triple the growth rate for large stocks.

These compelling figures -- and recent small-cap outperformance -- haven't gone unnoticed. Last year return-hungry investors poured about $8.4 billion in new cash into small-cap funds even as they yanked $4.7 billion out of other domestic stock portfolios. And already this year, investors have plowed another $7.7 billion into these funds.

Still, there are plenty of reasons you should think twice about committing big bucks to small stocks now. For one thing, it's always risky to jump on a segment of the market that's been hot for so long.

Plus, there are some indications that this small-stock surge has already begun to slow.

While it's true that Europe's fiscal problems have shaken the broad stock market throughout the year, the biggest wave of volatility didn't take place until May, when investors began to fear that Europe's slowdown could jeopardize the U.S. recovery.

And since April 23, small stocks have fallen 10%, while large-cap shares are off about 7%.

"As long as GDP continues to grow, we expect a strong rebound in small-caps," says Samuel Dedio, manager of Artio U.S. Smallcap. "But right now economic uncertainty is creating a psychological headwind for all stocks."

Also, your window of opportunity may have passed. Consider the following developments:

The economic downturn is over. The best time to invest in small stocks is several months before a recession ends. But the consensus among economists is that the recession ended last summer. And investments in small stocks tend to do poorly several months into a recovery.

Small stocks have already enjoyed a historic run. The 112% gain for small-caps between March 2009 and this April marked one of the best rallies ever for small shares. But investments in these stocks in the 12 months following 100%-plus surges typically lead to losses.

Small stocks have led the market for more than a decade. Small-cap dominance didn't just begin with this bull market. Since the end of 1999, small-caps have delivered annualized gains of 3.9%, vs. losses of 0.5% for large stocks. If history is a guide, this trend will reverse and revert to the mean.

Valuations are getting frothy. Even if the recovery stays on course, small-caps look less enticing than they did a year ago. "Based on current valuations, small-caps are significantly overpriced," says Jeremy Grantham, chief investment strategist for GMO.

None of this means you should abandon small-fry stocks altogether. But it does mean you should take these steps to fine-tune your portfolio in case small-caps slow:

1. BOOK SOME PROFITS NOW

Financial advisers typically recommend keeping about a quarter to a third of your equity allocation in small-caps. But there's a good chance your recent market gains may have pushed your small-cap stake above that target.

So rebalance your portfolio by booking some of the spectacular gains you've enjoyed in your small-cap stocks and funds. And use those proceeds to invest in stocks that have lagged lately and are undervalued as a result.

2. TILT TOWARD HIGH-QUALITY COMPANIES

The recent market surge gave the biggest boost to many of the tiniest and junkiest small stocks. Meanwhile, bigger and higher-quality stocks in the small-cap universe -- firms with tons of cash on their balance sheets -- haven't done as well.

But after the markets got slammed in May, shares of the biggest and most profitable small-caps held up better. Plus, "higher-quality stocks offer your best opportunity to buy future growth at low prices," says Grantham.

So within your small-cap holdings, favor funds that focus on companies with strong balance sheets, such as Royce Pennsylvania Mutual (PENNX) or Wasatch Small Cap Growth (WAAEX). Both are members of the Money 70, our list of recommended mutual funds and ETFs.

3. BROADEN YOUR SMALL-CAP PORTFOLIO

Some of the fastest-growing small companies can be found overseas (outside of Western Europe). So stash about 5% to 10% of your equity portfolio in foreign small-stock funds that invest in expanding economies abroad. Vanguard FTSE All-World ex-U.S. Small Cap (VFSVX), for instance, is a stock index fund in the Money 70 that invests most of its assets in small companies headquartered in Asia, Canada, and Latin America.

By holding shares of both domestic and overseas small companies, you'll be sure to benefit from faster-than-average growth -- wherever it can be found.