SMALL CAPS HOPE TO CRASH TECH PARTY: NASDAQ RALLY MAY SIGNAL LONG-AWAITED MARKET SHIFT

Behind the latest surge in technology stocks are signs that an even bigger rally is brewing, one that may finally encompass small-company stocks.

The average technology mutual fund is up 20.64% for the year through June 30, compared to the Standard & Poor’s 500 stock index’s 17.71%, according to CDA/Wiesenberger, a Rockville, Md.-based firm that tracks mutual fund performance.

Meantime, small-cap stocks have significantly underperformed their large-cap brethren for three-and-a-half years. The Russell 2000 index has climbed 4.4% for the year through July 21, a figure that is dwarfed by the rise in the S&P 500.

But all that may be about to change. Fueled by a charge in the stocks of such titans as Microsoft Corp. and Dell Computer, the technology-laden Nasdaq index has roared 4.45% this month. The Dow Jones Industrial Average and the S&P 500, by contrast, gained 2.66% and 2.75%, respectively.

The catalyst for the rally, which took investors on a roller-coaster ride last week, is optimism that the second half of the year will see improving sales of personal computers — thanks in part to falling prices and last month’s introduction of the new Windows 98 software. Despite evidence to the contrary, American investors also seem more confident that the Asian economic troubles will not cripple many technology companies.

As technology stocks, a staple of most small-cap funds, begin their climb back to health, a few market watchers are counting on the whole small-cap sector to tag along.

“Investors are starting to recognize that 25% returns are hard to come by,” says John Ballen, chief equity officer at Massachusetts Financial Services and manager of its $12-billion Emerging Growth Fund, which is heavily invested in such technology stocks as Cisco Systems, Computer Associates, Microsoft and Oracle Corp.

The realization may already be happening. Investors poured $3.27 billion into small-cap funds in the second quarter, up dramatically from $482 million in the first quarter, according to estimates by Lipper Analytical Services, a New York mutual fund tracker. That’s all the more significant considering that small-cap mutual funds have lagged large-cap growth funds, with one and three-year average annual returns of 18.5% and 20.4% through June 30, vs. 24.31% and 23.74%, respectively, according to CDA/Wiesenberger.

Tucker M. Walsh, a small-cap analyst at State Street Research & Management in Boston, also detects a shift in leadership.”We find the small caps very attractive right now,” he says. “If small caps in general continue to come through on the earnings side, people will start to gravitate toward the more growthier issues.” Mr. Walsh says opportunities for small-cap investors are likely to be concentrated in several sectors, including health care, financial services and consumer goods.

But not everyone is as optimistic. “The problem with small caps is that they tend to be illiquid,” says Peter Schliemann, an executive vice president at Boston’s David L. Babson & Co. and manager of the Babson Enterprise Fund, which has $230 million in assets. “As the market gets nervous about the direction of the economy, investors tend to flock to big, safe, liquid stocks.”

Shares in small companies tend to be less actively traded and a few buy or sell orders can move their price sharply. Even small-cap bulls admit it might take several quarters of soft earnings for large companies before investors warm up to smaller ones.

And the small-cap market has given watchers many false starts. A first quarter spurt — when the Russell 2000 beat the S&P 500 by four percentage points — was quickly quashed by Asian worries.

It also remains to be seen whether techs rally long enough to pull small caps along.

Several stocks took a beating last week due to negative forecasts from a handful of major companies. Computer Associates, for example, plunged a staggering 17? points to 39? after the software giant warned that Asia’s financial troubles will depress earnings.

Says Paul Wick, a managing director at Seligman Financial Services Inc. in New York who runs its $5.4-billion Communication and Information Fund, “People just don’t want to own things if there is any kind of problem or potential problem.”

But small-cap stocks seem ripe for the picking. Although they have higher growth potential, they trade at roughly the same price-earnings ratio as large-cap stocks, around 25 times trailing 12-month earnings.

Says Satya Pradhuman, director of small-cap research at Merrill Lynch & Co.: “If people start looking for some better values with higher growth rates, they are going to become smaller-cap investors without knowing it.”