Small stocks poised to outperform

The severity of the recent market decline really depends on your perspective.

If you were invested in the small-cap stocks of the Russell 2000 (IWM) index, things were pretty tough: You lost about 10% in the last two weeks of October as the index returned to early-September levels. The Dow Industrials, on the other hand, lost just 3% as it bounced gracefully off of its 50-day moving average.

Such a wide performance disparity is rare. In fact, large-cap stocks were outperforming smaller stocks at a rate not seen since the summer of 2007. In the months that followed, the Russell 2000 turned tail and outperformed the Dow by 32%. A similar but less severe drop in relative performance back in March was followed by a 63% outperformance.

So can small stocks once again outrun their larger brethren? The first question you're probably asking is whether stocks should be going up at all over the next few months. I think they will.

The lack of confirmation of the decline between the two asset classes provided additional evidence that the correction I had been expecting since mid-October (see post here) was about to end (see post here). As you can see in the chart above, large cap stocks still look pretty healthy. What this tells me is that major institutional investors aren't feeling panicky and dumping shares of their largest and most liquid holdings.

It was a different story back in June before the plunge that took the Dow down 6.6% and the Russell 2000 down 9.6% into July. Then, both large- and small-cap stocks were struggling. Both violated their 50-day moving averages in unison.

So, given the expectation of broad market gains why focus on smaller stocks? One of the most powerful forces in the market is the tendency to revert to the mean. Extended movements are like a rubber band being stretched -- sure it could continue stretching but it's more likely to snap back to normal. The same goes for the relative performance of the Russell 2000 to the Dow Industrials.

History is on our side too. Citigroup's small stock expert Lori Calvasina finds that November and December are typically strong performing months for small caps during the last year of a recession. Since 1927, small caps have finished higher more than 70% of the time in November and more than 80% of the time in December during years in which the economy stops contracting.

My positions

I've allocated a large portion of my portfolio at Wall Street Survivor to the Direxion 3x Small Cap ETF (TNA). My portfolio is up 14.2% for the week against a 1% decline for the S&P 500.

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.