Investment Contrarians

Small-Caps Sizzling, but the Rapid Advance Won’t Hold

By for Investment Contrarians |

Small-Caps SizzlingAt the beginning of January, I said “small-cap stocks will be a key driver of the broader market should the U.S. and global economy continue to improve” in 2013.

Small-cap stocks have been impressive early on in 2013, as the Russell 2000 is up 8.7% this year, increasing 2.3% in February alone, with the index trading at record highs above the 900 level. Small-cap stocks are easily outperforming the broader market in 2013.

In my view, continued economic renewal will drive small-cap stocks higher, as these companies tend to be able to react quicker to a changing economy.

The strong start to 2013 is also a bullish sign, as was the case in 2012, when stocks flew out of the gate. We are seeing a similar situation this year, so expect some gains.

But what I’m concerned about is the rate of the advance; in my view, unless you believe the Russell 2000 will gain 65% this year based on an annualized rate, the index’s rate of advance is clearly not sustainable. And you know this is highly unlikely, so you should expect to see ebbs and flows going forward. The last big year for the Russell 2000 was a 25.3% gain in 2010.

The chart of the Russell 2000 below shows the break at the horizontal resistance line that had been in place since 2011. While the relative strength and moving average convergence/divergence (MACD) indicators are both flashing “buy” signals, the angle of the recent breakout, marked by the blue oval, clearly indicates an unsustainable advance, so be careful.

Russell Small Cap Chart

Chart courtesy of www.StockCharts.com

I favor small-cap stocks for long-term growth, as the valuations are more attractive and may be worth a look for aggressive long-term investors.

And while I view the holding of large-cap stocks as an integral part of any portfolio, for added overall portfolio returns, I like small-cap stocks. These stocks add to the risk component of your portfolio, but you are compensated by a higher overall expected return from your investments. You can increase the expected return of a portfolio by simply adding more risk via higher-beta stocks. This is the advantage of adding small-cap stocks.

A stock with a beta of less than one has less risk than the market; hence, a lower expected return. A stock with a beta of greater than one, however, has a higher comparative risk versus the market, meaning possibly higher expected returns.

When there’s a stock market rally, high-beta stocks tend to fare better. But a note of warning—buying only higher-beta stocks does not necessarily translate into higher returns, as it also results in greater volatility and downside risk when the broader market declines.

The bottom line is: you need some exposure to small-cap stocks in your portfolio.

If the global and U.S. economies continue to show renewed growth, look to small-cap stocks to continue to outperform this year; but also be aware that the current rate of advance is not sustainable, so take some profits after rallies and look for put options to hedge.

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