Thanks to the Fed and lower interest rates, small caps are set to lead the market.
Small-cap groups include the S&P 600 Index and the Russell 2000 Index. With low interest rates, these indexes should beat the S&P 500 Index.
Within the group, some stocks will deliver larger-than-average returns. In fact, small-cap stocks tend to be among the biggest winners every year.
The 20 biggest winners since the start of the year started as small caps. They all had market caps under $1 billion. (Market cap is a measure of a stock’s size. It’s found by multiplying the share price times the number of shares the company issued.)
For comparison, the market cap of the smallest company in the S&P 500 Index is over $2.9 billion.
Recent changes in the Federal Reserve policy will make small caps even more appealing to investors.
Low Interest Rates Are Bullish for Small Caps
Last month, Federal Reserve Chairman Jerome Powell announced that the Fed will accept higher inflation.
This means, according to one analyst, that interest rates will be “…lower for considerably longer, if you believe as the Fed does that the recovery in the economy and the labor market is going to take years.”
While low interest rates benefit almost all companies, this is especially good news for small caps.
With low rates, bonds provide little income. So, large investors will search for higher potential returns. Many will turn to small caps to offset the low income in their fixed income portfolios.
Therefore, a small shift to small caps in pension funds is likely. Large investors’ buying will drive prices up.
Their buying also provides a level of support to small caps. These large funds tend to hold positions for longer periods.
Low rates are also bullish for small caps because more companies will find funding for their projects. When rates are high, investors are selective. At low rates, almost any company should be able to secure funding.
Former Fed Chairman Ben Bernanke explained why in a memorable way. He once noted:
…if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades.
In practical terms, this means that wind and solar energy farms will be attractive. So will research into improving these technologies. Many tech companies will find investments in this environment.
Although these same arguments apply to large companies, small caps offer better potential returns.
For example, if a new project generates $100 million in profits for a multibillion-dollar company, then the stock price may move up slightly. These same profits for a small company, on the other hand, could lead to gains of 1,000% or more.
Now, not every technology will succeed. Many small caps will not make it simply because their projects will fail. The trick is knowing which ones will take off and soar.
My colleague Ian King is finalizing some of his best research that captures the small caps likely to be the biggest winners. Smart Profits Daily readers will soon be able to learn about his latest findings, so stay tuned.
Michael Carr, CMT, CFTe
Editor, One Trade