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Small Stocks Are the Sweet Spot

08/25/2010 12:00 pm EST

Focus: ETFS

Todd Salamone

Senior Vice President, Schaeffer's Investment Research, Inc.

Todd Salamone and Elizabeth Harrow of Schaeffer’s Research write in Sentiment magazine that small stocks quietly have been setting the pace in the US markets.

The “aughts” have gained notoriety as a terrible decade for investors. From December 31, 1999 through December 31, 2009, the Standard & Poor’s 500 Index lost roughly 24% of its value, while the Dow Jones Industrial Average shed more than 9%.

In fact, that dismal ten-year period is now informally known as “the lost decade” among many investors.

These losses are even more disturbing when you consider that investors have historically regarded large-cap, blue-chip stocks to be a relatively safe haven during times of turmoil. When volatility reigns, says the conventional wisdom, play it safe by investing in big-name Dow stocks, where long-term returns are virtually guaranteed.

The bleak performance of large-cap stocks over the past ten years has left many investors with serious reservations about this traditional “safe haven” strategy. In fact, as a result of the market's stomach-churning turbulence, the entire concept of buy-and-hold investing has come under fire.

For example, in a recent roundtable, Forbes chief investment strategist Vahan Janjigian observed that buy-and-hold investing “certainly did work for people like Warren Buffett, but we’ve seen over the past few years that this strategy can really backfire.”

Not to be outdone, CNBC personality Jim Cramer recently warned viewers, “Never plan on owning a stock forever.”

Amid this buy-and-hold backlash, pundits have overlooked the outperformance of the Russell 2000 Index, which tracks a basket of smaller-cap stocks. Just like blue chips have—or had—a reputation for being “safe,” smaller caps have a reputation for being risky.

However, during the so-called “lost decade,” the Russell rallied nearly 24%. This remarkable price action suggests that it’s time to update the conventional wisdom.

In the current economic climate, smaller caps boast another advantage. Compared to their larger corporate cousins with sizeable global footprints, smaller-cap stocks are more likely to be sheltered from overseas turbulence.

Many fund managers have caught on, and appear to be shifting their focus to smaller-cap stocks. In fact, our analysis of option activity indicates that big money players have been accumulating the stocks in the [Russell 2000, which] continues to have the wind at its back from a technical perspective.

The index is trading above its 80-week moving average, which has [been a key] demarcation line between periods of bullish and bearish price action.

For those looking to take advantage of  [this] continued outperformance, active traders may want to consider investing in smaller-cap stocks that are characterized by low expectations on Wall Street.

By purchasing puts on the iShares Russell 2000 Index ETF (NYSEArca: IWM) in combination with your smaller-cap stock portfolio, you can protect your investment from serious suffering during major market declines.

Meanwhile, more passive investors or those with very long investment horizons may want to consider investing directly in the sector through IWM itself, perhaps using long-term calls to closely mirror the rewards collected by investors.

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