Small Caps and Cycles

Small Caps and Cycles...

"Roman historian Tacitus first noted that in all things there is a law of cycles; in that regard, not much has changed in the last 2000 years," notes Jim Oberweis , who explains cycles in small-cap stocks.

"Over the 1926-2004 period, small-company stocks have outperformed large-company stocks by a little more than 2% per year, on average. However, along the way there have been multi-year cyclical periods favoring small company stocks over large. From Dec 1973-July 1983, the stars were aligned for small-company stock investors. On average, small-stocks beat large-caps by 10.9% annually except for 1980, when both small-caps and large caps performed equally well.

"Satya Pradhuman, director of Small-Cap Research for Merrill Lynch, in his book Small-Cap Dynamics, points out that the single biggest long-term factor is economic growth. According to Pradhuman, smaller firms have greater economic sensitivity than large capsand thus tend to outperform large-caps when the economy experiences periods of rapid growth. To find a strong economy, look for sharply increasing industrial production.

"An appreciating dollar has historically correlated well with small-cap outperformance. Additionally, watch inflation. Inflation, per se, is not good for equities. In the short term, Pradhuman asserts that changes in market volatility should be closely observed. Periods of declining market volatility tend to favor small-cap stocks. Changes in market volatility affects the willingness of investors to assume risk; hence, when investor appetite for risk increases, small-caps tend to outperform.

"Predicting changes in the large-cap/small-cap cycle is challenging. One strategy is to simply remaining fully invested, pick good stocks, and accept the volatility of the cycles. Many, if not most, people try to emotionally guess (rather than fact analyze) the cycle and blow it. Many extrapolate the recent past and assume it will persist. Confidence tends to be highest when we approach the inflection point. When it seems like that either small-caps or large-caps will never come back into favor, it probably won’t be long before they do.