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Go Small or Go Home

There has been a big focus on the Dow Jones Industrial Average’s record highs lately, and what it means for the market. But while the Dow is a nice benchmark and sentiment indicator, it’s hardly a perfect representative of your portfolio or the entire market as a whole.

Here’s proof: Consider that small-cap stocks have produced 50% better returns since the November lows. Look at the S&P 500 Index versus its junior cousin the Russell 2000, and it’s plain as day. Since Nov. 15, 2012, The S&P is up about 14.3% through Friday and the Russell is up 21.5%.

Small caps are showing outperformance in the short-term, too, even if it’s not as dramatic. Since the start of the year, the S&P 500 is up about 8.7% while the Russell is up 10.6%. That’s 21% better for the little guys.

This might be just a market factoid that doesn’t matter. And as always, remember that past performance doesn’t predict future returns. But it’s noteworthy that investors are bidding up smaller companies right now — and that this trend seems to be sustained over the past several months.

The reasons for this are multifaceted. My short list of motivators includes:

Buyout Boom: I can’t figure out a way to prove it, but I think buyouts are a big part of the outperformance — and thus I think it’s a bit overinflated. After all, when a component stock like Hot Topic (NASDAQ:HOTT) gets bought out, the index naturally sees a bump. Since Bank of America (NYSE:BAC) or Pfizer (NYSE:PFE) will never see a buyout — and then a 30% pop as they get taken private — it’s perhaps natural for a small-cap index to outperform if a host of components have seen buyouts lately.

Risk Appetite: This could be a function simply of the “risk-on, risk-off” trade we’ve seen so much of. If you’re going to get risky and volatile, why not play with small emerging-market issues or biotech stocks that can pop more in a shorter period of time?

Hints of a Cyclical Rotation Into Equities: If the risk-on trade evaporates, so could the gains. But if this is a rotation into smaller, agile companies — those that have promise should the economy turn around — then this could be the first sign of a meaningful recovery. After all, behemoths like IBM (NYSE:IBM), General Electric (NYSE:GE) and Walmart (NYSE:WMT) take much longer to adapt to changing conditions. That provides stability in times of duress, but also means a slow start when things gear up again. Small caps are more immediately affected, and investors might be starting to focus on this investment category in anticipation of a 2013 turnaround.

Rotation and Lack of Alternatives: Of course, let’s not underestimate the churn that’s gone on in the last few years as folks move in and out of sectors and asset classes looking for short-term outperformance. The choppiness of materials stocks and commodities, the volatility of gold in the last 12 months — to a degree, this is driven by folks chasing the next big fad month-to-month and quarter-to-quarter. Small caps might just be the latest flavor in favor.

Innovation Bump: While biotech miracles, cloud computing and alternative energy are always nominally on the radar of big corporations, a lot of innovation comes from smaller outfits. Their size makes them more agile and can allow them to be ahead of the curve, creating a run-up in market value as they stick it to the big guys who can’t innovate as quickly. If that’s the case, small-cap outperformance might be a product of a technological boom rather than a broad-based recovery.

Anyway, those are just a few thoughts. What are yours? Share them below!

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Jeff Reeves is the editor of and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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