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Risk-On Market Puts Small-Caps In Starring Role

5 April 2013 in Trading Ideas

It certainly hasn’t been lost on investors that stocks have been on an incredible tear in the past few months. Since a mid-November low that had seen the broader market slip about 7% in two months, the S&P 500 surged nearly 16% into the end of last week.

Tough to beat, right?

Not exactly. Many investors in small-cap stocks were smiling even wider — the Russell 2000 index, a leading measure of small-cap performance, rose more than 23% during that same timeframe.

Such is the common phenomenon of the outperformance of small-caps when the general appetite of investors has been one of a greater willingness to take risk. As the Wall Street Journal recently pointed out, the Russell 2000 has risen 85% since January 2000, compared to a 7% rise for the S&P 500.1

Within that hunger for small-caps, however, lies a somewhat deeper truth: individual small-cap stocks tend to populate the year-end lists of best-performing stocks, and many investors are of the mind that finding just one of those stocks can result in huge profits. Does anyone even remember that Orexigen Therapeutics (OREX) topped the market in 2012 with a rise of more than 203%? Orexigen shareholders sure do.

The current thirst for small-cap stocks has led us to expand our catalog with the addition of our Small-Cap Stars motif, a portfolio of small-cap stocks of companies that have shown positive earnings and cash-flow growth during the past five years.

If the market continues to support risk-taking, this motif could potentially be reflective of those results – for better or worse.

Of course, small-cap risk is very real: the companies are smaller, their earnings are often more volatile, and in many cases these are younger firms trying to expand very quickly.

That, however, is the tradeoff – small-cap investing is thought by many to be a bet on higher long-term returns at the risk of shorter-term stock-price volatility.

1Brett Arends, “The Small-Cap Stock Trap,” The Wall Street Journal, Feb. 22, 2013.

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