I love investing in smaller companies.
As I wrote last week, smaller stocks tend to outperform larger stocks over time. And the effects are even more powerful when combined with the other five primary factors that drive my Stock Power Ratings system: momentum, volatility, growth, value and quality.
But I also know that markets often follow cycles. Certain sectors of the market do better or worse depending on how the economy is doing and what’s happening at the macro level.
This year has not been kind to small-cap stocks thus far. Over the past 12 months, the S&P 500 is down about 16%. But over the same period, the small-cap Russell 2000 is down more than 23%.
It’s not hard to understand why:
- Smaller companies are more sensitive to Federal Reserve policy. When the Fed drains liquidity out of the market, capital becomes scarcer, and smaller companies see their financing costs rise, as they have less negotiating power and market clout compared to their larger counterparts.
- Small-cap stocks are often growth stocks. These stocks suffer when the Fed raises interest rates because investors buy them based on earnings expectations years or even decades in the future. Those future earnings are worth less and less as rates rise when discounted into today’s dollars.
- Smaller companies are often more sensitive to economic downturns. The yield curve has been inverted for much of this year, which is a good predictor of recessions. The data, while mixed, points to tough times ahead. Even Amazon.com — mighty Amazon! — hinted in its Thursday earnings release that holiday spending might be leaner this year.
All of this has contributed to the rough year experienced by small caps.
And Now the Good News for Small-Cap Stocks!
Small caps crush everything else coming out of recessions.
All of the factors that hurt them when times are tough go into reverse and turbocharge them higher when the script flips. Financing costs fall, interest rates moderate and economic contraction turns into expansion again.
Bear markets “reset the clock,” so to speak, bringing valuations down to levels that support a prolonged bull market. The carnage of this past year has knocked the forward price-to-earnings ratio of the Russell 2000 down to just 13. That’s the lowest it’s been since the 2008 to 2009 bear market.
The historical precedents are good as well.
Prudential Securities measured the performance of the smallest 20% of stocks versus the S&P 500 coming out of recessions. Following all recessions going back to 1953, small-cap stocks outperformed the S&P 500 34% to 18% on average in the year following the recession.
But I want to pay special attention to the 1973 to ‘74 bear market and recession because I see this as being the most relevant to today’s world. Then, as now, the crunch happened after a prolonged tech boom. Soaring inflation and a major change in Fed policy were also features of both.
Well, coming out of that recession — and it was a nasty one! — small caps outperformed the S&P 500 by a 20-point margin, 58% to 38%!
Source: Prudential Securities.
And just for grins, let’s also include the 1980 recession, as this represented the end of another inflationary era. Following that recession, small-cap outperformance was even greater, crushing the S&P 500 by 32 points, 45% to 13%.
There is no guarantee that small-cap stocks will repeat that performance this time around. But history is on our side.
We may still have a little pain left in the current bear market, and another couple quarters of subpar GDP growth wouldn’t surprise me.
But when the timing is right, we’ll want to focus our investing in the areas most likely to outperform, and that includes small caps!
The size factor of my proprietary ratings system helps me identify stocks that are just large enough to capitalize on this move. Combine it with my other five powerful factors, and it’s a potent combo that creates opportunities for outsized gains.
And we just added a new small-cap stock to the Green Zone Fortunes portfolio. This company is tapping into growing demand within the health care sector, and it’s popped 16% higher in just two weeks!
That’s the size factor in action. If you’d like to gain access to this recommendation, along with a model portfolio that’s targeting the market’s largest mega trends, click here to watch my “Imperium” presentation for information on how to join.
I can’t wait to help you through this bear market and set your portfolio up for massive success when things turn around.
Until next time.
To good profits,
Adam O’Dell
Chief Investment Strategist