January 10, 2015
Indicator Spots Huge Potential
Winner in 2015's Comeback Sector
By Tom Vician
Small caps are typically expected to lead U.S. equities higher. In 2014, they shocked investors by underperforming their larger-cap counterparts. But a look at the charts shows they may make a comeback in 2015, and today I'll share a little-known indicator that could predict the next big small-cap winner.
In 1992, Nobel Prize-winning economists Eugene Fama and Kenneth French published their seminal paper, "The Cross-Section of Expected Stock Returns." They demonstrated that small-capitalization stocks tended to outperform large-capitalization stocks over time.
This makes sense from a risk/reward standpoint. Small caps are fledgling companies, and their stocks are often illiquid compared to large caps. These two factors make them volatile -- about 20% more so than the S&P 500.
Those companies that do succeed offer large returns as they grow their market capitalizations through great products and services. They can become some of the corporate giants we see today. Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT) and Cisco (NASDAQ: CSCO) all started out as small-cap IPOs.
In general, greater reward comes from assuming greater risk. And during market advances like we saw in 2014, small caps generally lead -- expect they didn't this time around. The Russell 2000 underperformed the S&P 500 by 7.9 percentage points. So what gives?
A few factors conspired against small caps in 2014, but they derive from one main source: overvaluation.
First, small caps were a victim of their own success. In 2013, the Russell 2000 rallied 37% while the S&P 500 gained less than 30%. By the end of the first quarter of 2014, the small-cap sector looked frothy.
According to Bloomberg, at the end of March, the Russell 2000 had rallied for a record seven straight quarters. This launched small caps' valuations into the stratosphere, putting them 26% above their peak in the 1990s, before the tech bubble burst.
This even led to concerns from the Federal Reserve. In February, Fed Governor Daniel Tarullo cited small caps' big run up as a reason policymakers should be wary of creating systemic risk in financial markets.
Less than two weeks after Tarullo's statement, the Russell 2000 peaked, beginning a two-month slide while the S&P 500 ground its way higher. The Russell managed to claw its way back up to a new high in July. But then Fed Chair Janet Yellen put the kibosh on small caps again.
In her semi-annual Monetary Policy Report to Congress, Yellen stated, "Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms."
Small-cap overvaluation took nearly a year to work itself out through time and price. The Russell 2000's price-to-earnings ratio (based on one-year forecasted earnings) dropped to 16.9 at the end of Q3 2014 from 19.6 at the end of 2013. This seemed enough to entice investors, and small caps began outperforming in Q4.
Technically, they have shown signs of an important bottoming process and their first green shoots. In the weekly chart of the Russell 2000, we see support in the form of dual uptrend lines (points 1 and 2).
The lower panel of the chart shows a ratio spread between the Russell and S&P 500. Simply put, a rising line indicates small caps are outperforming.
The Russell 2000 broke two downtrend lines (point 3) -- one from August and one dating back to March. This shows a change in trend from underperformance throughout most of 2014 to outperformance in Q4 (point 4).
The clouds over small caps are beginning to lift, and this will allow leading stocks in the sector to shine in 2015.
Despite the struggles last year, one little-known indicator uncovered three small caps that trounced the returns of the sector and the broader market. Called the Alpha Score, this indicator combines proven technical and fundamental metrics to peg those stocks most likely to make huge moves higher. It assigns a value from zero to 200, and as you can see below, stocks with high Alpha Scores can deliver monster returns.
Moreover, the Alpha Score just alerted me to a new small-cap leader you've probably never heard of. This company doesn't do anything flashy. In fact, most would call its business boring. It makes thermal and acoustical barriers for car engines and insulating and filtration products.
Like I said, boring. What is exciting is the firm's profitability.
This company prints money hand over fist, as evidenced by the earnings and revenue growth of the past four quarters.
Its Alpha Score of 166 places it in the strongest 6% of all companies based on this proprietary indicator. These are the kinds of market-leading stocks the Alpha Score helps find before everyone else catches on.
With the small-cap sector showing renewed signs of life, now is the time to position your portfolio in leading stocks. A rising tide lifts the strongest boats the quickest.
If you want more information on how the Alpha Score works or to get in on its latest small-cap pick, follow this link.
Additionally, for the next few days, I'm offering my Top 10 Picks for 2015 based on the Alpha Score. Believe me, this isn't your usual list of top picks. Last year, this indicator spotted several of the fastest-growing stocks of the year -- stocks that went on to soar as high as 266%.
I can't guarantee these 10 picks will be as successful as the previous ones. But I would highly recommend you take a few minutes to at least look at these top picks. Just remember -- this free report will only be available for the next few days. So if you want to get my Top 10 Picks for 2015, click here now.
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