Why Small-Caps Will Lead the Market Rebound

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 |  Includes: CYBX, KVHI, TTEK, ZINCQ
by: Thomas Englebert

It's not easy watching your portfolio erode on a daily basis. The Dow is down 16% for the year, the Nasdaq is down 15%, and the Russell 2000 Small-Cap Index is down 12%. Consumer confidence is near the lowest level since 1980.

It's at this stage that many investors will reach a tipping point, the point where they throw in the towel to stop the pain. It's called capitulation.

The problem with capitulation (the act of selling your investments and walking away from the market for safer investments) is that you do it when you're in an irrational state of mind. Fear and greed drive the market and right now fear is in control. In times like this, one would do well to remember the old saying "Buy into fear, sell into greed."

Oil and gas prices are at record highs, banks are facing insolvency, there is war in the Middle East with possible escalation, a housing crisis, inflation, et cetera. Given the current predicament and the consistent doom and gloom outlook. We would like to take this opportunity to present the contrarian approach.

Conventional wisdom almost always makes the most sense just before it is proven wrong. Just as the night is darkest before sunrise and as sure as night turns to day, this economic storm will pass.

Oil Returns to Market Value

In our opinion, the oil bubble will burst. There are just too many speculators that are not going to and have no intention of taking physical delivery of a barrel of oil. Moreover, the current price of oil exceeds its intrinsic value. At $147.00 a barrel, the playing field changes. Drilling and new technology increases proportionately, coupled with changing consumer habits to increase availability and subdue demand. 

Is the world economy going to continue its growth? Sure, but we believe new energy technologies will offset this growth, even more so as technologies previously thought too expensive become price efficient. Many economists now believe oil is fairly priced for 2020 assuming the world continues to grow at its current pace and no new technology is brought online.

Oil is a cyclical commodity that traded for less than $20 a barrel just ten years ago. While the market may be susceptible to short term manipulation, in the long term the market will ultimately deal with price inefficiencies, which is what we currently have.

The panic buying you are seeing in the oil industry can only lead to one result, the same result whenever you have rampant speculation regardless of the commodity in play: a total bust. For those that would argue that this time it's different - it's never different!

These speculators will abandon the oil play just as fast as they created it. They created and abandoned the dot com bubble. They created and abandoned the housing market. The speculation in oil, which has come at great cost to the average citizen, will soon subside. Think in cyclical terms and it's much easier to understand.

It's the nature of the beast; you can only run a market up so far, so fast, before another exchange becomes more rewarding. To those buying into oil futures after a 1000% increase in ten years and expecting another 1000%, I say good luck.

So what happens when the oil bubble pops? Gas prices return to around $2.50 a gallon only because elasticity has taken place. The dollars rises (or vice-versa, the dollar rises and gas returns to $2.50 a gallon), inflation is held in check, the economy grows, and housing makes a comeback. Throw in the recent stability in Iraq and Afghanistan (which is already occurring if you read the foreign press) and you have the makings of a large scale economic recovery. A domino effect to the positive side.

Raising interest rates to strengthen the dollar will expedite this scenario. "An ounce of prevention equates to trillions in market cap."

Why Small-Caps Now?

History teaches us that the biggest gains are often had when people think things will never get better. There have been nine recessions since 1953, lasting between seven and sixteen months each. Small-cap stocks have gained an average of 11.4% during these recessions. They averaged a 13% gain one year after the recessions, a 76% gain three years after the recessions, and hold on to your hats, a 506% gain ten years after the recessions. 

Consider the eventuation coming out of the 1974-1975 recession. Small-cap stocks gained 53% in 1975 compared to 37% for large caps. Small-Caps again beat large caps in 1976, 57% to 24%. In fact small-caps beat large caps for eight years running from 1975 to 1982. Market cap aside, both categories rewarded investors who stayed the course or invested when others were selling. 

It is our opinion that the current sell-off represents an exceptional opportunity in small-cap stocks, both in the short term and for investors with a 3-5 year time frame to invest their money.

A final reminder, you don't get rich by doing what everyone else is doing. Think contrarian, there will always be overlooked investments that are undervalued by the market.

Small-caps we like: KVHI, ZINC, CYBX, TTEK.

Disclosure: No position.