Large Caps to Lead in 2007? It Would be a Rarity.

Do you know where the hot spot for stocks in 2007 is likely to be? Odds are you've already heard the consensus outlook from the media - large cap stocks are supposed to lead a rally this year, according to many Wall Streeters. Well, what if we could show you some eye-opening charts that might make you rethink the theory? We've got a couple of ideas leading us to believe those large cap prognostications may not be telling the whole story.

But first, a little history....

Why Would Now Be Any Different?

Remember predictions from 2006, 2005, and even 2004? The same large cap forecasts being made now were being made then. Just as a couple of examples, for 2006, Schwab's Chief Investment Strategist favored large cap growth stocks. Merrill Lynch Investment Manager's chief investment officer called for large caps to top small caps in 2005. A Standard & Poor's mutual fund strategist was expecting 2004 - the second year of a recovery - to push large caps to the pole position. And, they weren't alone - most institutions were thinking the same way.

As it turns out, the 'experts' went 0 for 3. Small and micro caps led 2004 and 2005, while the mid caps led 2006. Small caps and micro caps ran a close second last year.

Fast forward to today. A small army of commentators and pundits feel the 'matured' economic cycle and a likely end to the Fed's rate hikes are a prime environment for the bigger companies to thrive in (finally). So, we're hearing the same large cap song as we heard the year before. ING's 2007 outlook favors large cap stocks, and they recommend underweighting small and mid cap stocks. The reason? They say large cap company earnings have been generally stronger than expected since 2003. They also feel small and mid cap valuations are overextended, meaning it could be tough to tack on more gains from those two groups. Van Kampen's market cap advice for 2007 is even easier to digest...."Go Big", meaning look to large caps.

Most of the logic makes some sense.....sort of.

My logic is a little different though. I think the small and micro cap stocks are likely to perform better than any other group in 2007, as has been the case for the majority of the last several decades.

Yes, perhaps it's a bit self-serving to say so, considering the nature of our site. But, we didn't choose to focus on small and micro cap stocks by accident. Over the long haul, small cap stocks tend to yield an annual return 1% to 2% better than large cap returns. That may seem minimal (and it is) on a one-year basis, but compound that small difference over 5, 10, 20, and even 50 years. Given enough time, a small cap portfolio can turn out many times larger than a pure large cap portfolio. Sure, large caps may lead from time to time, but by and large, we've observed the smaller companies create the bigger gains.

And when you have the ability to hand-pick your micro caps, then look out - we think the long-term bottom line potential gets even sweeter.

A Picture is Worth a Thousand Words

To really drive the point home, today we'll look at a longer-term, percentage-change charts of the key major market cap groups (large, mid, and small/micro). The chart may look a little different than normal, as it should - we're not looking at a specific index history. Rather, we're plotting the percentage change of a market cap group from a specific point in time. This gives us the ability to compare apples to apples, or in our case, compare small and micro cap returns to everything else.

Roughly, our small cap chart plots the returns of the smallest 1/5 of all listed stocks, all of which qualify as micro-caps in our book. Their market valuation is usually no greater than $200 million, and frequently much, much less. Of course, adjustments were made as stocks began to meet or not meet that criteria. Though we primarily deal with bulletin board stocks on this site, this listed micro cap group closely mirrors the over-the-counter market. So, we feel comfortable making a comparison between the two. We used the biggest 1000 stocks as our large cap proxy, and then the next biggest 2000 stocks for our mid cap data.

In any case, we think the chart speaks for itself. (Click here to go to a full-screen version: http://www.smallcapnetwork.com/scb/wp-content/uploads/2007/02/021207mcpercentchangesince1992.gif). Going back in time as far as we could and still get accurate data (1992), the micro caps have done significantly better than the large caps. Not surprisingly, the mid caps - the 'middle' third or so of all listed stocks - did pretty well too. The large caps even led for a while in the late 90's, but clearly, the best longer-term results were yielded by anything other than large cap stocks. Research other than our own (and a lot of it) also comes to the same conclusion about stronger small and micro cap returns, using even a much longer time frame than we did.

Did you notice something even more amazing? Take a look at the period between 2000 and 2003 (click here for a full-screen version: http://www.smallcapnetwork.com/scb/wp-content/uploads/2007/02/021207mcpercentchnagesince2000.gif). Remember the horrific bear market? The large caps bore the brunt of it - perhaps the price paid for their unusually strong returns during the couple of years before the three year slide. During the technical beginning and end of the bear market, the micro caps actually gained ground. (Kinda' makes you wonder if the 'large caps are safe and less volatile' theory actually holds water.) You can also see how mid-caps at least held their own during that time.

More Than Just a Fad

With everything we said above still fresh in your mind, we'll just make one last comment about the general expectation that large caps will lead in 2007 - perhaps the forecast is actually that large caps will only do better in 2007 than they usually do. And sure, maybe they'll even do better than any other group this year. Who knows? But, the way we see it, small and micro caps still have the edge when it comes to pure bottom line potential, even if they include a little extra volatility. Needless to say, we plan on continuing to bring you our best small and micro cap trading ideas, as the odds still seem to favor them yielding the best overall results.

We know some of you are new-comers, so we're glad we got to deliver this message to you sooner than later. We hope you'll keep all of today's thoughts in mind as you consider our ideas going forward. That picture above really is worth a thousand words.

By the way, we hope each of you considers our small cap trading ideas as we deliver them to you. At the very least, we think it's a great way to learn, and you may also find yourself reaping some pretty big rewards in the process. But, if individual stocks aren't your thing, why not take a look at the iShares Russell 2000 Small-Cap Exchange-Traded Fund (NYSE: IWM) or the Vanguard Small-Cap ETF (AMEX: VB)? If you're thinking even more aggressively, there's the iShares Microcap Index ETF (NYSE: IWC), which tracks the performance of the smallest 1000 stocks of the Russell 2000.