3 Reasons to Buy Small Cap Stocks – October 26, 2023
We are witnessing one of the largest pullbacks in recent years.
Most stocks are under significant pressure.
That said, here are 3 reasons to buy small cap stocks.
Look around the investing landscape and you’ll find every reason in the world not to own stocks. Pundits point to sky-high interest rates, a weakening consumer, rampant energy prices, Middle East conflicts, and more as arguments to sit on the sidelines.
This popular wait and see attitude is a sure way to not participate in the eventual resurgence of stocks.
Making the case to buy one of the riskiest areas of the market (small caps) may sound utterly ridiculous. That’s until you look at the facts.
Truth is, we’re not only observing a major drawdown for smaller equities, but valuations have reached some of the cheapest levels in decades.
Does that mean the all-clear signal is here? NO.
It indicates that the severely-bearish posture by investors is reaching an extreme.
Today, we’ll unpack the money flow picture. Then we’ll dive into evidence-based data signaling a brighter outlook for stocks than the disciples of doom suggest.
3 Reasons to Buy Small Cap Stocks
The best investing opportunities arrive when all hope is lost…basically when everyone has thrown in the towel.
Markets are approaching dire levels of pessimism.
You can observe this by looking at our popular money flow indicator, the Big Money Index (BMI). Not only have we been oversold for 19 days, we’ve reached a reading of 18% this morning.
Keep in mind, the oversold barrier is 25%. Today’s level is the shallowest mark we’ve recorded since the pandemic low on March 23rd 2020.
Reason number 1 to begin adding to small cap stocks is simple: deeply oversold conditions.
History shines bright on stocks when they reach oversold levels. As stated last week, stocks show powerful gains once the BMI breaks through to the upside from oversold levels.
A year later the S&P 500 surges 15.5% on average.
It’s not a matter of if stocks will stage a powerful rally, but when.
I’ve overlaid the BMI on the Russell 2000 ETF (IWM) for reference, given the magnitude of the drawdown. This has been the market albatross all year:
From this standpoint, stocks are exhibiting capitulatory levels. Nearly all stocks are under immense sell pressure.
Small caps are showing an unbalanced level of carnage. Consider this, yesterday the Russell 2000 closed at 1651.43, a hair above the June 16th 2022 close of 1649.84.
Even more eye-popping is when you rewind the tape further. We’re now at levels back to early November 2020!
To say this is a big selloff is an understatement. From a high-level perspective, this is reason 2 to start shopping the small-cap aisle:
Now, that we know money flows are extremely negative and overall prices are resting in the lower band the last 3 years, let’s size up one major behavioral difference that small caps are exhibiting today.
When you go back in history and study major bear market bottoms, small caps tend to outperform a year later.
Battered small caps typically outpace large caps once major lows are in. You can visualize this below with each major bear market going back to 1982.
The 2022 bear market is behaving very differently with the Russell 2000 mightily underperforming the S&P 500:
In the last 40 years, small caps have never lagged by this magnitude. We are witnessing history, folks.
Abnormal circumstances often present big opportunities.
Up to this point I’ve laid out a technical picture, which in my view sets up an eventual reality. Extreme negative positioning will crest and money will flow back into shunned areas.
Now let’s take a stab at the fundamental picture.
The third reason to own small cap stocks comes down to good old fashion valuation. We are now wading through one of the cheapest price to earnings levels seen in decades.
Below reveals how the S&P Small Cap 600 sits at a rock-bottom forward P/E of 11.42. Back to 1999, the average NTM P/E is 14.81.
Current valuations are trading at a 23% discount:
So, the million-dollar question you should be asking is how do small caps perform after such depressed valuations?
I’m glad you asked!
If your assumption is stocks are entering some Book of Revelations type of moment, consider the following study to better inform those fears.
Since late 1999, I referenced all month-end forward P/E ratios of 11.8 or lower for small caps. Prior to today, that resulted in 22 discrete periods.
Those include:
- 2008 – 2009 Global Financial Crisis
- 2020 COVID-19 Pandemic
- 2022 Inflationary bear market
We’re talking about some of the biggest financial moments in history. Here’s the takeaway to print out and stick on your refrigerator.
Once small caps trade at or below an 11.8 NTM P/E:
- 3-months later the group is up 3.5%
- 6-months later it’s a gain of 9.8%
- 12-months later and you’re staring at 18.8% gains with a 77% positive outcome
Check it out:
That’s a lot of green!
Does this mean we’re at the end of the current selloff? No it doesn’t.
However, finding a positive narrative in a sea of red is likely a worthwhile endeavor. At least history says so!
So, I encourage you to view today’s market washout as not only a great buying opportunity, but a big one at that.
Chances are when you look back years from now, you’ll be glad you did.
Let’s wrap up.
Here’s the bottom line: There are 3 reasons to buy small cap stocks. First, our Big Money Index is oversold. It’s now sitting at an area last seen at the pandemic low.
Rarely do moments like these come around.
Second, small caps are at November 2020 levels. There must be some valuable companies under-the-surface. Focus on best of breed stocks in position to lead once money rushes back into markets.
The third reason is simple, Valuation. A rock bottom P/E lends itself to powerful forward returns back to 1999. Once the forward P/E drops below 11.8, small caps leap a crowd-stunning 18.8% a year later.
The evidence is overwhelming that better days lie ahead.
Stocks won’t be oversold forever. That means that eventually institutions will be putting massive capital to work.
Don’t wait for the media bull-whistle to blow before buying high-quality stocks…you’ll miss the parade.
Be ahead of the market.
Follow the money.
Author: Lucas Downey