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[mitchzacks]

3 Reasons I Think it’s Time to Buy More Small-Caps

Before you go out and load up on small-caps, it’s important to first consider yourcurrent asset allocation. If your portfolio already has a sizable allocation(25% or more), then it probably won’t make sense to bulk up even further. If you own much less than that, then you’ve got some reading to do (below).

3 Reasons I Think Small Caps Could Outperform This Year Historically, small-cap stocks tend to outperform large-caps in the early stages of bull markets. The reason is that the early stage of a bull market typically corresponds with a v-shaped economic recovery, which tends to favor cyclical, commoditized industries that benefit most from rapid growth off the bottom. And that’s where small-cap companies thrive. But as a bull market ages, leadership starts to change, cyclical industries start to feel the pinch of slower growth rates and tighter financing, and investors start to lean towards more defensive, well-established and cash-rich large caps/multinationals. Those types of companies are better able to weather economic downturns. Which begs the question: isn’t this bull market technically in its “maturation phase,” i.e., the twilight years? And, wouldn’t that imply that large caps should outperform? Generally speaking, yes, it would imply that large caps should do better. But, it’s important to remember that just because large caps typically outperform late in bull markets, it does not mean they’ll always outperform. Indeed, even as recently as the 2003 – 2007 bull market, we saw that small-caps can lead all the way through. I’m not implying that small-caps will outperform large-caps for the remainder of this bull, however I do think conditions dictate they could have a good run in the medium term. Here are 3 reasons why: 1) A Stronger Dollar Hurts U.S.-Based Multinationals – a stronger dollar implies weaker foreign currencies, which means it’s progressively becoming more expensive for foreigners to buy US goods. US corporates reported over $18 billion in negative currency impact in Q4. With the Fed set to hike rates this summer, while other central banks loosen, the dollar could get even stronger. Multinationals could experience weaker foreign sales as a result, which could pinch share prices. 2) The U.S. is Leading the World Economically – small caps generally tend to benefit from a strong domestic picture, and when you consider an improving labor market, lower gas prices and the fact that consumer spending saw its fastest growth from Q3 to Q4 last year since 2006, it looks ripe for small-caps to do well. 3) Mean Reversion – small-caps significantly underperformed large-caps over the last year. I think small-caps could make up some of that ground from here. Bottom Line for Investors 

I’m a firm believer that just about every well-constructed, diversified portfolio should have a reasonable (10% - 20%) allocation to small-cap stocks. Over long periods of time, history tells us that the expected return from small-caps is higher than the expected return of large-cap stocks. Of course, small-caps won’t outperform their larger peers every year, but on average they should generate a stronger rate of return over time. 

That doesn’t imply that it makes sense to build a portfolio entirely composed of small-caps. Doing so could expose your portfolio to greater degrees of volatility and introduce additional risk that you’d be better served to diversify away with other asset classes and styles. 

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[allstarcharts]

About That Big Range in the Russell 2000

With the S&P500 and Dow Jones Industrial Average getting all the glory based on recent all-time highs, it’s the Small-cap Russell2000 that’s been struggling to reach that milestone. We’ve now been stuck in this range since the 4th quarter of last year. We’re not making lower lows, but we’re also not hitting higher highs. A frustrating sideways range is really the only way to describe the small-caps.

The first chart shows the weekly candlesticks for the Russell 2000 Index. Notice the overhead supply near 1210 and downside support near 1080. This 140 point range representing the consolidation can either be a correction before the next leg higher, or a more complicated topping formation. It’s hard to tell at this point, so waiting for a confirmation is likely our best bet:

The blue line represents the uptrend line from the 2009 lows. A break of that line simultaneously with a break of the lower end of this range could be disastrous for this market. The bearish momentum divergence down below increases that possibility. This downside confirmation would then give us an initial target of 940 based on the 140 point range since late last year. But until that level is broken, there is no action to take here from a more structural perspective.

Looking shorter-term, we can get a better look at this range. Here we’re looking at a daily bar chart with prices towards the upper end of the sideways channel. The lightly shaded area right in the middle of the range represents some important gaps and former support/resistance within this sideways action. I would get much more bearish if we break down below that level, which would also represent a break of the 50 and 200 day simple moving averages. This would likely lead to a 3rd test of this key support.

Overhead supply has been tested twice. A third test of that would increase the likelihood that the resolution out of this range will be to the upside. Another test of this downside support, however, would make that the 4th test of that level and would most certainly lead to an eventual break. So I believe holding on to the 1150 level, or so, is really important to this market.

This has definitely been a frustrating place to be for both the bulls and the bears this year. Sideways markets tend to be some of the most difficult to trade. But I think putting everything in perspective helps us formulate a game plan that we can execute as the market provides more information. For now it’s still a no-touch, but I promise you that the longer these consolidation take to resolve, the bigger the eventual move once a direction has been determined. So I think it’s worth pointing out now and then following closely. I believe a monster opportunity is coming soon.

Stay tuned….

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