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Small-Cap Investing: How to Play The Emerging Small-Cap Rally

 January 07, 2009 05:13 PM

Forget the grim news that Alcoa (NYSE: AA) is slashing costs and cutting 13% of its workforce. We all know times are tough. But the market's a forward-looking beast. And right now, it's doing exactly what I predicted on November 19. It's favoring small caps over large caps.

In December the little guys put up big numbers - a 5.8% gain versus a mere 1.1% uptick for the large guys, based on the Russell 2000 and S&P 500 indexes.

Before I get to my favorite ways to screen and play this emerging small-cap rally, let me first address my critics.

My last column failed to convince some of you. Others thought I simply skimped on the proof. Or more specifically, that I failed to tell you why NOW is the right time to buy small caps.

[Related -Do Earnings Mean Anything Anymore?]

As they put it, "We all know small caps lead the markets out of a recession. But what makes you so convinced we're on the way out?"

As my college physics professor liked to say before each lecture, "Prepare to be enlightened."

Why It's Prime for Small-Cap Investing

Let me first disclose, I'm not a market timer. I don't look for single infallible data points to signal my buys or sells. Instead I track trends (both long and short term). And there's no denying the trend at the National Bureau of Economic Research - the committee responsible for officially uttering the economic curse word, recession.

You see, these guys - albeit a collection of the most educated and intelligent economists - have a knack for being late. By the time they make the call, the recession is usually close to over. Or in the case of the last two recessions (1990 and 2001), over completely.

[Related -Alcoa Inc (NYSE:AA) Q4 Earnings Preview: What To Expect?]

This time will be no exception. The government's about to dope up the economy on stimulus packages. In other words, plenty of economic growth is in the works. If you're skeptical spending massive amounts of money we don't have will do the trick, I understand. But just realize, something will prove to be the catalyst for a turnaround. And the numbers belie that something will materialize very soon:

  • Since 1900, the average recession lasted 14.4 months.
  • And since World War II, only two recessions (1973 and 1981) lasted longer than 15 months.
  • So strictly by the numbers - based on a start date of December 2007 for the current recession - odds are this recession will be history by early spring.

You could argue, if you dare utter the words that "this time will be different," that we've never experienced such a financial collapse. And the averages could be meaningless.

Fair enough. But again, I challenge you to recall any other period when so much stimulus (in the form of obscenely low interest rates, tax breaks and massive government spending) poured into the markets with no impact.

It doesn't exist.

Ultimately, we're at the tail end of this recession.

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