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Why Purchasing Underperforming Stocks is a Wise Move in the Current Market Scenario Why Purchasing Underperforming Stocks is a Wise Move in the Current Market Scenario

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When legendary analyst Bob Farrell’s “10 Market Rules to Remember” was published, the first rule was that “markets return to the mean over time.” This principle, although not directly applicable to individual stocks, can be extended to sector and style analysis of stocks.

If, for example, a particular sector like industrials has been underperforming for a defined period, an eventual period of outperformance can be anticipated as the sector reverts to its mean performance. Similarly, the relative performance relationship between different styles of stocks, such as growth stocks and value stocks, tends to revert to its long-term average at some point.

Applying the same principle to the difference in companies’ sizes, it becomes clear that small cap stocks are due for a period of strength. Although they might have underperformed for some time, small cap stocks generally outperform large cap over the long term, and this relationship is likely to be restored in due course.

Despite the popular belief that small cap stocks are riskier than large cap stocks, data shows that over extended periods, small cap funds outperform their large cap counterparts. This is largely due to the higher volatility associated with small cap stocks. While they may suffer larger losses in a market downturn, they reap greater gains during market upswings, resulting in overall larger gains over time.

An illustrative example can be seen when comparing the performance of the SPDR ETF tracking the small cap Russell 2000 index (IWM) versus the large cap Dow tracker (DIA) since their inception. The data demonstrates that IWM gained 302% compared to DIA’s 255% over the given time period.

DIA and IWM

However, in a contrasting scenario in the last two years, IWM lost 5% while DIA gained 11%. The reasons behind this divergence include the fact that small cap stocks are more adversely impacted by a rising interest rate environment compared to large cap stocks due to their typically higher debt and lower cash reserves.

DIA and IWM

Surprisingly, despite the expected market strength propelled by anticipation of rate cuts, small cap stocks have remained weaker. This seeming anomaly indicates that a reversion to the mean is on the horizon. When this occurs, small cap stocks not only need to catch up with large cap but also surpass them to reestablish their relative outperformance.

While the timing of such a market shift is inherently uncertain, the current juncture presents a compelling opportunity to position portfolios for this eventuality. The potential of this strategy is further accentuated by the fact that a persistent attempt by the Fed to temper market expectations will predominantly affect large cap stocks, leaving small caps relatively less affected. If the Fed indeed reduces rates later this year, small caps are poised for significant gains.

It is evident that small cap stocks are due for a resurgence. At present, large cap stocks are priced attractively due to favorable market conditions, while the risks are disproportionately priced into smaller companies’ stocks. This unique situation presents an opportunity where small caps have a reduced downside and an increased upside potential, making the investment in small caps a risk worth taking.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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