⭐️ Spotlight Hour: This May be the Strongest Group of Stocks of 2021 | Trade Stocks

This May be the Strongest Group of Stocks of 2021

By Wed, Dec 30, 2020

We’re all quite ready to say goodbye to 2020. Many people have suffered profound personal setbacks, and the broader U.S. economy likely shrank more than 2%, according to the Federal Reserve’s Open Market Committee (FOMC). A surge in unemployment, renewed social restrictions due to COVID-19’s spread, and a general lockdown on leisure spending have put the proverbial damper on things.

Against that backdrop, many wonder how the stock market can be doing so well. The S&P 500 is finishing out the year with double-digit gains, after a sharp dip and then a profound recovery. For small-cap stocks, the swings have been even more pronounced. The Russell 2000 small-cap stock index has posted a roughly 20% gain in 2020.

And history says this rally is just getting started. To understand that, we need to go back 30 years. The U.S. economy was quickly losing steam in 1990. By the fourth quarter, gross domestic product (GDP) had fallen 3.5% from the year-earlier quarter. That should have spooked small-cap investors. (Small-cap stocks are generally defined as having market values between $300 million and $2 billion). Instead, investors started to buy small caps aggressively, anticipating an eventual economic rebound.

The Russell 2000 Index of small-cap stocks bottomed out at the end of the third quarter of 1990 at 119, but it would hit 144 by year-end (even though the economy slumped badly that quarter) and would hit 178 by the following May. That’s a 50% gain in just seven months, even though the economic data painted a bleak picture. (The index went up to about 200 by the end of 1991, even though GDP growth didn’t prove to be robust until the first quarter of 1992.)

Why would small-cap stocks, presumably the most economically sensitive of the three major asset domestic stock groups (large caps and mid-caps being the others) rally amid a recession? Because savvy investors know that smaller companies can see an especially strong rebound in business once the economy regains its footing.

And all signs point to 2021 being a far better year than 2020. As the COVID-19 vaccines roll out across different groups, look for employers to re-hire idled staff and consumers to unleash a wave of pent-up spending. The FOMC predicts a 4.2% jump in GDP next year, which would be the strongest showing since 1999.

Why should you expect a vigorous rebound in spending? Accounting for wages and salaries, government payments, wealth, interest rates, taxes and demographics, IHS Markit estimates that consumer spending is 7% lower than one should expect. Consumers have instead been trying to keep a lid on spending and boost savings.

According to the St. Louis branch of the Federal Reserve, the personal savings rate typically hovered around 7%-8% in recent years. As of November 2020, that figure stood at 12.9%. Once they grow confident that the worst of the pandemic crisis has passed, consumers will again spend those savings on houses, cars, travel, restaurants, and more.

Small-cap stocks — which derive a higher portion of their sales domestically than mid and large-cap stocks — will be a prime beneficiary of that spending upturn.

The good news: small-cap stocks remain cheaper than their mid and large-cap peers, despite a strong fourth-quarter rebound.

The iShares Russell 2000 ETF (IWM) is valued at 14.75 projected 2021 earnings, according to Morningstar. That figure rises to 21.44 for the Vanguard Mid-Cap ETF (VO) and 21.95 for the SPDR S&P 500 ETF Trust (SPY).

We’ve already seen the kind of meteoric surge that small-cap stocks can deliver. This past summer, I recommended shares of Innovative Industrial Properties, Inc. (IIPR) when its market value was just around $2 billion. Since then, shares have more than doubled.

Shares of Inseego Corp. (INSG) have rallied nearly 50% since my early September recommendation.

And when I recommended BioTelemetry Inc. (BEAT) in mid-October, its market value was squarely in small-cap territory. A 61% gain in the past 10 weeks means this stock has graduated into the class of midcap stocks.

I believe that, at a minimum, investors should have broad-based exposure to this dynamic asset class. And we can get that by selecting the ideal small-cap ETF.

Most investors will focus on the largest funds in the group, such as the iShares Russell 2000 ETF or the Schwab U.S. Small-Cap ETF (SCHA). But we are talking about growth here, so the ideal pick for an economic upturn is the SPDR S&P 600 Small Cap Growth ETF (SLYG). According to the sponsor, this ETF is based on an index that “includes stocks that exhibit the strongest growth characteristics based on: sales growth; earnings change to price; and momentum.”

The fund charges a reasonable 0.15% annual expense ratio and has delivered an 11% annualized return over the past decade. It’s a broad-based fund, and no single investment accounts for more than 1.4% of the portfolio.

Action to Take: Buy shares of the SPDR S&P 600 Small Cap Growth ETF (SLYG) up to $88 and lock in profits when shares reach $120.

About the Author

Contributor David Sterman is a certified financial planner and has worked as a financial journalist and investment analyst for more than 25 years.