Researchers have sifted through nearly 25 years of reports on violent crime. And when they were combined with a study of U.S. economic cycles from the National Bureau of Economic Research (NBER), the conclusions were compelling, if also a little macabre…

Violent crime, the data shows, trends higher at the start of a contraction in the business cycle and typically stays there during the early stages of a recovery.

And it’s not just violent crime where this pattern holds. It turns out that petty and grand larceny follow a similar trend. Barron’s reported that stickups rose significantly in ’73, ’80, ’81, ’90, and ’01. These were all years that the U.S. entered recessions.

It seems pretty intuitive, doesn’t it? Call this the Les Miserables Indicator if you like. When even a good man is stealing, the economy must be awful…

I guess we will add robbery and murder statistics to the economic data we monitor. I’m not quite sure I’m kidding about doing that…

Anecdotally, here in Baltimore where we are headquartered, violent crime got off to a stronger start this year than the Orioles typically do. The week after New Year’s Day, Baltimore was averaging over a homicide a day. As of today, the count for 2007 stands at 30, with four this week alone…and it’s only Thursday…

You’re probably asking yourself what this has to do with small-caps.

Well, crime aside, we think small-caps are going to have another good year in 2007.

Fed Chairman Bernanke sees the U.S. economy actually expanding over the next two years, with domestic growth improving with some firming of the housing market.

Whether Bernanke is right about 2007 and 2008 or the police blotter tells the true tale, I want to be invested in small-caps no matter what the economy gives us the next two years. Here’s why:

When I look back over the decades, as far back as the 1920s, small-cap stocks have typically gained about 13% per year. Compare that to the 10% gained by blue chips over the same period of time. Over many 10-year periods, small-caps trounced large-caps by as much as 50 percentage points!

The lesson here is that if you want to make a fortune, odds are that keeping your capital invested in the stock market for long periods of time is a good idea. If you want to make an even bigger fortune, history suggests having a significant portion of your portfolio concentrated in small-caps.

Of course, that 3% difference between small-caps and large-caps comes at a price. Small-caps often don’t pay a dividend, and they usually are not as mature as businesses as large caps. It makes them riskier, and that’s partly why their returns are superior. The more risk you accept, the greater returns you expect…

But if we look back again over the last century, we see that small-caps really shine over large-caps when the U.S. economy is growing. And for the majority of the last 80 years, the U.S. economy has been growing.

Let’s hope Bernanke is right. And don’t obsess too much over crime stats. Instead, buy the best small-cap values you can find. We’ll keep bringing them to you in Small-Cap Strategy Report and Small-Cap Insider.

Until next time,
Craig
February 15, 2007

Crime in Economic Downturns was originally featured in the Penny Sleuth.