The Russell 2000 reached an all-time high of 1295.80 in June 2015, but by mid-January had plunged more than 20%, putting the small-cap market by definition into a bear market. The S&P 500, Dow Jones Industrial Average, and NASDAQ Composite all entered correction territory during the month, seeing drops of more than 10% down from the highs of these indexes.
While oil and China are the commonly-named culprits for the market downturn, there is also an enormous amount of uncertainty regarding corporate earnings. For instance, analysts are expecting a 6% drop in EPS for the stocks in the S&P 500 for the fourth quarter of 2015. As companies continue to report earnings in the coming weeks, there is a strong possibility for any ultra-negative surprises to throw a twitchy market into panic.
On the positive side, investor sentiment is exceptionally bearish about the market. Investor sentiment tends to be a contrarian indicator; when sentiment becomes highly bullish, a correction or bear becomes more likely, and when sentiment leans significantly towards the bears, an up market becomes more possible. A little good news could go a long way towards propping up the current market and driving a sustained rally.
When it comes to small-cap stocks, pessimism tends to run amok when it rears its head. You’d never know by the current market behavior that the P/E of the Russell 2000 excluding negative earnings stands at just 21.2, compared to a P/E of 21.4 for the S&P 500. The reduced liquidity and lower institutional coverage of small-cap stocks means that volatility is amplified and fundamentals become ignored.
So is it time to go shopping for small-cap bargains? As always, prudence should be any investor’s watchword. There are a number of companies covered by the SmallCap Informer that have seen prices fall in sympathy with the small-cap indexes and not due to any identifiable problems on their own.
When searching to add to positions in your existing portfolio, or to identify stocks profiled in the past in the SmallCap Informer that might be attractive bargains at their current valuations, subscribers should start with the Stock Data Table in the latest issue and refer to the projected total return column.
Note, however, that the companies with the highest projected total return are often the most aggressive picks—stocks that have posted recent negative quarterly results or experienced other troubles. On the other end, companies with the lowest projected total return are often those with the best performance to date, but represent stocks that are at the high ends of their valuation ranges.
That leaves companies in the middle, with total returns moderately higher than 15%, that are generally the best candidates to consider at this point in the market cycle. Do your due diligence as always, but don't be fooled by stocks with lower prices that have likely fundamental reasons for their declines.
When the total returns of covered stocks are plotted on a graph, they tend to form a traditional bell curve, with few companies at the extreme high and low ends, but more companies clustering in the center. Focus on those companies to find the most reasonable stocks to add to your portfolio during market downturns.
- DOUGLAS GERLACH