Every now and then, incredible opportunities stare us in the face.
We are in the midst of one of those moments right now.
The hard part, of course, will be acting on it.
Nearly a week ago, I told you how my favorite oversold signal triggered.
Imagine receiving the green light on stocks at the COVID lows in March 2020…then the October 2022 inflation bear market bottom. That’s what this rare datapoint alerted.
It’s signaling another opportune time for stocks now… But this time, it’s in small-cap land.
As we always do here in TradeSmith Daily, we’ll let history guide us… and help prove that small-cap stocks deserve a bigger place in your portfolio.
Small Caps Are Mightily Underperforming Large Caps
Any way you slice it, small companies have suffered in 2023.
A laundry list of market headwinds includes:
- Rising interest rates, spurring capital flight from equities to “safer” Treasuries
- Quantitative tightening, causing a restrictive policy stance
- And overall downbeat market sentiment
When the macro backdrop gets murky, risk assets like stocks come under pressure. Small caps in particular have been hit extra hard relative to large-caps.
Below reveals what I mean. On a 1-month, 3-month, and year-to-date basis, the S&P Small Cap 600 has vastly underperformed the large-cap S&P 500:
You may be curious why small-cap stocks are underperforming so badly.
It has to do with their cyclical nature.
The top 3 sectors in the S&P Small Cap 600 are Financials, Industrials, and Consumer Discretionary, representing nearly 50% of its exposure. All of these sectors are highly vulnerable to losses in a recession.
As fears of a hard landing mount, investors sell these sectors first and ask questions later.
Given how we’re now 80% finished with 2023, small caps are trailing large caps by a wide 16.2% gap. This has pushed valuations to dirt-cheap levels.
Right now, the next 12-months forward P/E for the S&P Small Cap 600 sits at 12.1 vs. 18.2 for the S&P 500 large-cap index.
This makes small caps extremely cheap compared to large caps, putting it at one of the lowest valuation spreads in decades.
More importantly, small caps are trading at a mega discount of 28% compared to their historical average P/E of 16.9x.
When you contrast that with large caps being 8% more expensive than their long-run average of 16.7x, a juicy setup emerges.
11 Years, $18 Million “Stock Genome Project” Ready For Launch
Our data scientists spent over a decade and $18 million mapping out the DNA of over 50,000 stocks and funds…
It’s all part of a new initiative we’re calling the Stock Genome Project.
It was able to identify dozens of winning stocks last year I – even as the overall markets dropped 20%.
2023 could be even better.
Bet Big On Small Caps Right Now
As investors, valuation needs to be a huge part of your stock-picking process.
A general rule of thumb is when markets are trading at 20 times earnings, they’re expensive. Levels near 10 times earnings are cheap.
Given that small caps recently clocked a rock-bottom P/E of 13.37, the pendulum has swung towards cheap. And history shines favorably on stocks when they get this oversold.
Over the past 20 years, when small caps have measured a 13.4 FY1 P/E (its expected earnings over the next year) or lower on a month end basis, green shoots appear.
Three months later the group gains an average of 1.9%.
The 6-month average jumps to 6%.
12 months later they rip 17.5%… almost enough to put them in a new bull market:
Returns like these are why you should bet big on small caps now. Rarely do stocks get this cheap… and rarely do they stay oversold.
Gloomy times eventually breed zoomy times!
If you’re looking to play for a bounce in small caps, consider the iShares Core S&P Small-Cap ETF (IJR). It tracks the S&P Small Cap 600 and has a tiny expense ratio of .06%.
— Keith Kaplan
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Source: TradeSmith