Should you jump on the bandwagon?
We are just about one third of the way through 2010, and over the last 13 months the market has been on an unprecedented tear. The Russell 2000 small cap index has screamed 112% higher since the March 2009 lows. Take a look at the 2-year chart of the Russell below and you’ll see that there were only three sizeable pull-backs: one in July, one in November, and the most recent in February.
Right now investors need to decide: should they jump on the bandwagon and try to ride this rally higher or should they throw their hat in the ring with those calling for a pull-back? A lot of analysts are saying that a pull-back is well over due - and I tend to agree. But just because we believe something should happen, doesn’t mean it will happen.
The case for a market decline is compelling. Stocks in the S&P 500 are trading near the top of their historical PE range during an upward cycle, with an average PE of just about 23.4. Yields on the index are getting increasing low, now just below 2% on average – well below the 3% historical dividend yield. This means investors are paying more for a stock that generates lower dividend payments than they have historically been willing to pay during an upward moving market.
But there are still tons of bulls out there. Investors Intelligence has reported that just over 50% of stock market advisors are bullish, and that the average mutual fund cash level is a mere 3.5 percent. That tells me that institutional money has been supporting this rally for some time now, and it’s not likely to flee all at once.
So my advice for individual investor right now is to be cautiously optimistic. Don’t sell all your winning stocks in anticipation of a pull-back, but also don’t put all of your available money to work buying stocks with high valuations.
Rather, consider trimming some of your underperforming positions in order to raise cash. This may be prudent if these stocks haven’t kept pace with the market’s advance, and you don’t see business improving for those particular companies. These are likely to be the stocks that will fall hardest if a pull-back does come.
Also, if you raise some cash now, you will be ready to invest should we get a pull-back. And if no decline comes, then you still have cash available when you see a great opportunity. Sometimes the best investment you can make is no investment at all, and while inflation is always a concern, a few months isn’t going to crush the value of your dollars.
Take a measured approach to buying and selling stocks, and view investing as something that is done over time – not all at once. And make sure you are constantly looking at small-cap stocks!
Historically, small cap stocks have outperformed over the long-term. And looking forward, I’m optimistic that small caps will outperform once again in 2010. The case for small-caps is compelling, and a little historical perspective helps to make my point that owning stocks in this asset class is a must have for every investor.
***Remember the dark days in 2009? They were not that long ago. The market headlines were often disturbing at best, downright depressing at worst, but always thought provoking. I remember reading an article in the Wall Street Journal, The Lost Decade of Stock Investing, on October 15. The premise of that article was that Americans were sold a load of garbage, to put it succinctly, by financial advisors. It said that advisors told us to expect an average gain of 7% annually on our buy-and-hold stock portfolios, and 5% annual gains on our real estate investments.
But the article went on to illustrate that if you invested $100 in the S&P 500 at the end of 1999, then ten years later you’d still need a 34% rally just to break even, and a 72% rally when adjusting for inflation.
The lost decade means that 10 years of supposed stock market gains were wiped out by the latest recession and stock market decline. In fact, many investors even lost money, especially those that paid high brokerage fees.
But you wouldn’t have lost money if you’d purchased an index of small cap stocks such as the Russell 2000 small cap index back in 1999. That’s why I am consistently bullish on small-caps, and why they are a critical part of your investing strategy.
Investors who purchased the Russell 2000 small-cap index at the end of 1999 would have earned 23.5% on their investment by the time that Wall Street Journal article was written on October 15. That’s a full 57.5% greater return than investors in the Standard and Poor’s 500. But even more importantly, you would have made money, instead of lost it. The same holds true as of today. Since December 31, 1999 the Russell is up 44% while the S&P 500 is down 19%.
Recall that the Russell 2000 small cap index is comprised of 2000 stocks ranging from just a few hundred million dollars in market cap, up to $4.5 billion, with an average market cap around $360 million. The index is considered the barometer for small cap stocks. For more information on the index, visit the Russell Investments website, which you can access by clicking here.
History has shown that small-caps consistently outperform large caps on the upside. But the reverse is also true. Small-cap decreases in share value are typically greater than with large-caps. Those big pullbacks are buying opportunities, as I discussed at the beginning of this issue. But either way the market moves in the short-term, small caps tend to outperform over the long-term.
Small-cap stocks offer investors a number of benefits including better overall returns, potential for huge gains, and diversification. In fact, it’s even been shown that by purchasing highly risky small cap stocks, investors can actually lower the risk in their overall portfolio – especially when investing in emerging markets. This is possible because these stocks can move inversely to the broader market – they may go up when others go down.
I’m an eternal optimist, and have built the reputation of my newsletter advisory products around the promise that individual investors like you and me, can do better than the S&P 500. Here in Small Cap Investor Daily, and in my Small Cap Investor PRO advisory, I show readers how to do this by investing in the right small cap stocks.
But not just any small-caps, I look for the ones with big potential for financial out-performance and share price gains.
