“When you look back over the last 10 recessionary environments, what tends to lead back on the upside is small-cap equities.”

— William Greiner, Chief Investment Officer of UMB Asset Management

“Like springtime crocuses, small-cap stocks flourish once the harsh cold of a bear market is over… Because small-caps are undervalued once the market turns around, they benefit disproportionately from an earnings recovery.”

— Larry Light, Wall Street Journal

As investors scour the market for stocks that will be the quickest to bounce back once the market recovers, they need look no further than the small-cap sector. Penny stock gains outpace the blue chips on average during a rising market. Take as an example, the brief rally that occurred earlier this week…

In the rally that started Friday afternoon and continued throughout Monday’s close, it was the small-cap stocks that led the charge. In no way am I saying that the market has finally found it’s bottom, but it’s a nice reminder that small-cap stocks have historically led the way out of bear markets.

As you can see in the chart below, from 2 P.M. last Friday through the market’s close on Monday, the Dow gained 10.72%. During that same timeframe, the Russell 2000 Index gained 14.57% and then S&P Small-Cap 600 gained 13.83%.

It only seems fair that the small-cap sector would see a bigger bounce since the penny stocks have taken a brutal beating during the past few months. Over the past three months, the Dow has lost around 26%, while the Russell 2000 and S&P Small-Cap 600 both fell a staggering 39%.

Heading into bear markets, penny stocks have historically fallen the harder and faster than the large-caps. As investors get skittish, they often flee to the perceived safety of the blue chips and let the penny stocks fall by the wayside.

The small-cap stocks, however, are also the quickest to rebound once the market reverses course. As the bear market comes to an end, the penny stocks get the biggest bounce as earnings recover and valuations return to more logical levels.

As the market sentiment becomes more bullish, investors are attracted by the profit potential of the more speculative penny stocks, and they often leave behind their diluted positions in large-cap stocks and low-risk bonds.

That being said, now is a great time for small-cap investors to load up on cheap penny stocks. There are severely undervalued stocks strewn about the small-cap sector and savvy investors can grab some great deals right now. Once the market finally begins to recover, these investors will see the quickest gains and the biggest profits.

Best regards,
John Schuler

November 26, 2008

Small-Caps Lead the Charge in Most Recent Rally was originally featured in the Penny Sleuth.