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There’s “conventional wisdom” out there that as a bull market matures, large cap stocks tend to become the out-performers. According to this thinking, investors tend to shift investments to companies with well-established revenue sources, market penetration, and huge stockpiles of cash as a bull market ages. In theory, and for the most part in practice, these are the companies better suited to weather an economic downturn.

This means that small caps tend to get slighted in the late stages of a bull, but I think there are some circumstances in the current environment that argue for the opposite. Indeed, I see some good reasons now to bulk-up on small caps in context of a diversified approach.

3 Reasons You Might Want to Bump-Up Your Small Cap Allocation

When we start working with new clients at Zacks, we tend to notice that folks are under-allocated with small cap stocks. Often, the response we hear is that small caps are “too risky and volatile.” While this is true, relative to large caps, it is far less true when you factor in the potential long-term growth benefit. In that sense, it is arguably riskier not to own small caps.

A look at the last 15 years provides a good example for what I mean here. From 2000 – 2014, small caps (using the Russell 2000 Index) as a category have annualized +7.4%, compared to the S&P 500 which annualized a much lesser +4.2% over the same period. Looking back further, a hypothetical $1,000 investment in Russell 2000 at the start of 1979 was worth $29,742 at the end of 2014, while the same investment in the S&P 500 would have been worth $21,468. That’s a +2,874% gain versus a +2,047% gain, a difference that isn’t exactly a rounding error!

I’ve just argued for the long-term, total return reason to own small caps in your portfolio, but I think there are circumstances now that could boost the performance of small caps over other categories over the next year.

1) The Dollar Is Strong and Likely Getting Stronger – small cap companies consist largely of U.S.-based companies that derive a large percentage of their revenues and profits from domestic consumers. That means they are largely insulated from the hindrance to exports caused by a strengthening dollar, which multi-nationals “feel” on their top lines.

2) Rising Interest Rates Shouldn’t Hurt – a rising rate environment generally hurts small caps since they are more leveraged than larger companies. High levels of debt in a rising rate environment hurts small companies because interest payment costs rise. But since interest rates are basically zero bound and the Fed has made it pretty clear rate rises will come very gradually, this should not be as negative a factor where it has been in the past.

3) Merger and Acquisition Opportunities – often, small caps are the targets of M&A activity since they’re the easiest targets. That usually means a nice boost for stock prices, since the ‘acquiring companies’ usually have to pay a premium for ownership. In the U.S., if M&A activity continues at its current pace, it could reach $4.58 trillion which would be the biggest year on record.

Bottom Line for Investors

Small cap stocks have proven over the long-term that they deserve or, perhaps, even require a place at the table when investors are making asset allocation decisions. I believe this to be true over the long-term – and, I think the narrative of small caps being ‘too risky and volatile’ is causing investors to slight them when they construct investment portfolios.

At Zacks, we try to educate our clients about the long-term benefits of owning small caps, if doing so is appropriate given their goals and objectives. And for investors with long investment horizons seeking growth, this is usually the case. I also believe small caps are worth considering for the short term. As you know, investment success is all about the future, immediate as well as in the years ahead.

Download Zacks Latest Market Strategy Report to See Where Equity Markets are Going

Small capitalization stocks are an interesting breed. This portion of the markets contains thousands of names that are unloved and unappreciated. The space is a treasure trove for long-term and disciplined individual investors. In a series of posts, I will explore some nuances of the space that make it so incredibly appealing to the discerning investor. But, buyer beware because there is a lot of junk in small cap.

Dozens of studies have demonstrated that investors myopically focus on bottom line earnings. I'll add to that and say that the behavioral bias has morphed. Whereas the bias used to focus at the individual stock level, it is now the case at the index level. In a decidedly opposite twist of the classic cliche, investors can't see the trees for the forest. Why? The move to passive indexing has obfiscated the most basic principal of capitalism. Money should flow to the best opportunities for investor return.

How each of us defines, "opportunity" is subjective. Opportunity can be defined as a stock trading below book value, a biotech firm about to receive FDA approval, and everything in between. In the upper realm of high finance, this concept of opportunity is referred to as "intrinsic value". The avenue by which the market realizes intrinsic value is called "price discovery." Passive indexing is nothing more than allocating to the market, pro-rata based on a company's existing size. It, therefore, negates price discovery. Indexing is decidedly investing in mediocrity. Indexes are, after all, capitalization weighted AVERAGES by definition and construction.

Most investors may be surprised by the wide dispersion in returns of index constituents that exists. We looked at small capitalization stocks back to 1964 and found the group of stocks, weighted equally, returned 12.3% annualized over the 50+ year period. That roughly equates to the return of the Russell 2000® Index, though the index did not start until 1979. Now it gets interesting. We cheated by ranking stocks based on their future return over the next 12 months and put them into five buckets (quintiles). We then measured the average 12 month return from 1964-2015. Keep in mind, these exact same stocks generated the 12.3% annualized return I referenced earlier. If you were an investor with perfect foresight and you could invest in the bucket of stocks with the best forward 12 month return, your portfolio would return 65.2% per year for over 50 years. On the flip side of the equation, if you had some sadomasochistic tendencies and invested in the bucket of stocks you knew would perform the worst over the next 12 months, your portfolio would have returned -50.8% over the next 50 years. Again, these are the exact sames stocks that when combined in a weighted-average index return, generate 12.3% per year.

The trouble with evaluating the success or failure of an asset allocation model over a short period of time – or in real-time – is that one of the primary benefits to the strategy involves non-correlated assets – and correlations aren’t constant.

A given asset class, like emerging market equities or corporate bonds for example, will display an oscillating amount of correlation to any other given asset class over any multi-year period. And then, in the next multi-year period, that correlation could change markedly once again.

Consider that REITs and Treasury bonds could either move in lockstep, move in opposite directions or switch back and forth in completely random cycles. However, when the lens is widened and you take several steps back, the non-correlated nature of two asset classes often begins to shine through – thus demonstrating the free lunch concept and its virtues for a retirement-bound investor.

We want non-correlated assets over the long term because their differences in performance allow us the opportunity to rebalance from winners to losers and pick up potential premiums that other, more short-term oriented investors are dropping at our feet. This is a logical, sound and proven strategy – but it is a strategy that many have a tough time sticking with.

It’s frustrating to an unsophisticated investor when three quarters of their portfolio is going up and one quarter is going down. The response is almost always something along the lines of “Why can’t we just own the stuff that’s going up now?”

LPL is out with a mid-year outlook piece that has lots of interesting information in it, but I especially liked this portion about how the benefits of non-correlated asset allocation sometimes don’t show up…

However, despite the near universal acceptance of the importance of diversification, having a diversified portfolio does not automatically mean investors will outperform or gain value in risk reduction.

This was best demonstrated in 2014, when despite a sixth consecutive year of stock market gains, some investors might have lagged, as most segments of global financial markets failed to keep pace with many of the popular domestic stock market indexes. The broad S&P 500 Index and the Nasdaq Composite Index finished the year up 13.7% and 14.8%, respectively, and solidly outperformed other diversifying asset classes, like small cap or international stocks, by wide margins. Investors taught not to keep “all their eggs in one basket” and diversify their portfolios were left wanting more, as their investment performance trailed these broad U.S. benchmarks.

And 2014 is not a sole outlier, as diversification failed to benefit investors twice more in recent years. In fact, the S&P 500 Index has outperformed an equal weighted portfolio of the most common equity asset classes used to diversify (mid cap, small cap, developed foreign, and emerging market stocks) by a combined average of roughly 5% in three of the past four years. Not since 1998 and the Asian Crisis, when international stocks suffered and small and mid cap stocks also underperformed, has such a large performance gap between the S&P 500 Index and the other segments of the global stock market existed.

So why not just invest in large cap stocks or the S&P 500 and abandon the notion of diversification? Simply put, to do so would be a mistake of overvaluing a short term phenomenon over a long-standing investment axiom that benefits more than it hurts. In fact, over the past 20 years, the S&P 500 has only outperformed all other major asset classes (including small, mid, foreign developed, and emerging markets) 30% of the time, and it was the worst performing asset class 25% of the time. This demonstrates the importance of investing in at least several different types of investments. Diversification has historically worked and it remains the core tenet of portfolio strategy.

And here’s a table showing both non-correlation to the S&P as well as “batting average” against the S&P for a few asset classes over various time frames:

Josh here – it’s interesting how easily investors can focus on the recent underperformance of EM stocks vs the S&P 500 (a 25% batting average) and forget about the outperformance in a prior, longer period of time (58% batting average in the decade ending 12/2012). This obsession with recency and forgetfulness of longer term results is the opportunity for patient investors to pick up.

Source:

LPL Financial Research – 2015 Mid-Year Outlook

In the latest edition of Stocks For the Long Run, Jeremy Siegel offered up a great stat on the small cap premium. From 1926-2012, small cap stocks returned 11.5% per year while the large cap S&P 500 returned 9.7%. But if you were to exclude the 1975-1983 period, which coincides with ERISA laws that made it easier for pensions to diversify into small caps, the annual returns for both large and small caps would be almost identical at around 8% per year.

Of course those returns did happen and you can play that game with most historical data-sets, but the small cap premium has been called into question more and more as of late. You can look at historical data going far back into the past, but I prefer to look at actual products in the small cap space since it would have been quite difficult to put together a cost effective small cap portfolio before the 60s or 70s.

Surprisingly, the Vanguard Small Cap Index Fund (NAESX) has a performance history dating back to 1960. The annualized return through March 31 of this year is 10.84%. In that same time the S&P 500 returned 10.19% per year so there was a slight premium in this particular fund. DFA has a small cap fund (DFSTX) that goes back to 1993. The annual returns through the end of 2014 show this fund outperformed the S&P 500 by over one-and-a-half percent (10.94% vs. 9.36%).

So there are real funds that have shown an edge over longer time frames in small caps. People offer many reasons for the historical small cap premium — more risk, less liquidity, a smaller following by Wall Street analysts, not as easily investable by large institutional funds, etc. And these reasons make sense on the surface. But that doesn’t mean they’ll work going forward. No one really knows how these dynamics will change over time.

The days of making easy money in stocks are over (if they ever really existed). I don’t believe you’re not going to be able to make a minor tilt to a simple factor and watch huge profits roll in anymore. They’re too widely known and easier to invest in than ever. Small caps are just one example. Premiums will still exist, but my guess is they’ll get compressed. Maybe I’m wrong. It could be that investors just have to be willing to show more patience going forward.

But I think it makes sense to invest in small caps whether they earn a premium over large caps in the future or not. This is because they provide diversification benefits. Take a look at the cyclical nature of the return numbers on the Vanguard Small Cap Index Fund and the S&P 500 over the years:

Markets are messy, but to a diversified investor these numbers are beautiful. When one segment of the market had a relative string of underperformance, the other was there to pick up the slack. I don’t see this changing anytime soon as large cap stocks continue to become more global while small caps are more U.S.-centric.

There are other ways to invest in smaller stocks that have shown an even more impressive historical return record including a tilt to value or quality stocks within the small cap universe. Again, no one really knows how those risk premiums will fair in the future. But a portfolio with an allocation to small cap stocks should continue to provide a nice diversification benefit to investors that are able to look past the inevitable periods of relative underperformance.

That’s how diversified portfolios work. There’s always going to be something that’s doing better and something that’s doing worse. The payoff is that the disciplined investor earns a more balanced risk-return profile for their troubles.

Source: Stocks for the Long Run

Further Reading: What Happens When the Umbrella Shop Gets Too Crowded? The Small Cap Value Cycle The Small Firm Affect is Real and It’s Spectacular (AQR)

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

The Russell2000 is a market that has frustrated the majority of its market participants over most of the past year. Sideways trading ranges tend to do that. It’s not fun. Lack of trends whip around traders until they just throw in the towel and give up. This is a big reason why I think big bases tend to have explosive resolutions. The frustrated participants that give up, now have jump in late to try and play catch-up. It’s the fear of “missing out” that drives price higher. There is an old saying that goes,

“The bigger the base, the higher in space”

. I believe we have exactly that in the Russell2000 Small-Cap Index.

The first chart shows the weekly candlesticks in a sideways range over the past 16 months. We have now tested the upper end of this range four times since it first peaked in March of last year. The more times that a level is tested, the higher the likelihood that it breaks. I believe an upside breakout is coming any minute and we want to be buyers of that breakout. The catalyst, to me, is the failed breakdown in October below support from last February and May near 1080:

The upside target based on this consolidation is above 1320 which represents the 161.8% Fibonacci extension of the entire correction from last year. This represents around 10% from current levels. Risk management-wise I don’t see any reason to be long if we are below all of this overhead supply from the past year. But above it and we want to be all over it. The best part is how well-defined the risk becomes upon an upside resolution.

Here is a short-term look at this consolidation. This is a daily candlestick chart showing this sideways range since late 2013. The overhead supply is very clear. Each time that price has approached this level, the sellers have taken control. Every time prices get there, by definition fewer and fewer sellers are there to sell, because many of them have already sold. Eventually when the sellers dry up and demand takes control, that’s when prices are driven higher. I believe this happens soon:

Look at that failed breakdown in October. I think that will be the catalyst to drive this higher. The upside target is above 1320 and based on how long prices have consolidated in a sideways range, I believe we hit that target quickly.

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