Small Cap Stocks Offer Big Returns
What a difference a week can make!
Just last week, the broad market was hitting new highs as investors celebrated strong earnings reports.
Then, Fed chair Jerome Powell hosted a press conference in which he discouraged reporters from expecting an interest rate cut this year.
And over the weekend, Trump shifted his tone on the China trade talks. It now appears that there will be new tariffs going into effect on Friday, taxing billions of dollars of imports from China.
These two news items have shifted the tone of the market, and stocks have been trading lower this week.
But that doesn’t mean you have to lose money.
In fact, these shifts from the Fed and President Trump open up a new area of opportunity for you to take advantage of!
New Risks Hit Blue Chip Companies the Hardest
The mainstream media has made a big deal out of the Fed’s tougher take on interest rates and on Trump’s hardball trade tactics.
This makes sense, because most traditional investors are focused on the biggest “blue chip” stocks in the market.
Since the companies behind the biggest stocks typically carry large amounts of debt, the Fed’s tougher stance on interest rates can be a significant risk. As interest rates rise, the costs that big companies have to pay for new debt has the potential to drag down profits.
Also, keep in mind that these big blue chip companies are heavily engaged in international trade. They buy supplies and raw materials from overseas partners. And then the products these big companies produce are sold not just here in the United States, but around the world.
With so much international trade exposure, the threat of more tariffs will naturally cause investors to think twice about owning these stocks.
So it’s no wonder big blue-chip stocks have moved lower over the past week.
But as an investor, you don’t have to sit back and take their lumps from this pullback. Today, I want to show you why small cap stocks actually have an advantage in this market. And why investing in these smaller domestic companies will give you an edge as we move into the summer months.
Let’s take a look at three reasons small cap stocks should do quite well despite the new risks from this past week.
Reason #1: Strong Dollar Favors Home-Grown Companies
The Fed’s tougher stance on interest rates has an important effect on currencies. And that’s a problem for big international companies based here in the U.S.
When Powell made it clear to reporters that the Fed was not considering cutting rates this year, market-based interest rates in the U.S. moved a bit higher.
At the same time, central banks from other countries have been cutting interest rates in an effort to stimulate their own economies.
When rates are steady (or higher) in the U.S., and lower in other countries, big investors have more of an incentive to hold dollars. After all, they can earn a better return on deposits because of our steady interest rates. This means more international capital will be moving to the U.S., driving the value of the U.S. dollar higher.
Now, this may sound like a good thing. But for American companies with lots of international business, it is not.
That’s because the strong dollar makes it more expensive for international customers to buy our products and services. And when profits are earned overseas in “weak” international currencies, those profits translate to smaller gains when reported in dollar terms.
Add it all up, and smaller companies that create products and services here in the United States — and sell those products and services to Americans — have a competitive advantage over big blue chip companies.
In today’s market, we’re seeing investors move money out of big blue chip stocks and into the stocks of smaller companies that are focused here in the U.S. That’s leading to strong performance in small cap names even while the overall stock market pulls back.
Reason #2: Trade Issues are a Bigger Deal for Big International Companies
Another reason we’re seeing smaller stocks do quite well is because these companies have less to lose from an escalating trade war.
Smaller companies based in the U.S. have fewer international customers. In particular, small cap companies in the retail, energy, and financial industries are largely immune to the trade challenges that investors are worried about.
Niche retail companies tend to focus on building their brand here at home before expanding into international markets.
And with the U.S. economy still very strong, energy companies like oil producers can sell to refiners here in the U.S.
Keep in mind, oil prices are still well above their lows from the beginning of the year, helping to support higher stock prices for American energy stocks.
Small bank stocks have also been doing exceptionally well over the past few weeks as American businesses continue to grow, and the potential for stable interest rates allow banks to generate profits from lending to these businesses.
In short, the small businesses that concentrate on serving American customers are doing just fine in today’s environment.
And as investors move capital to these names, we should continue to see small cap stocks perform better than their large cap peers.
Reason #3: Small Cap Stocks are Still Well Below the 2018 Highs
One final reason I expect small cap stocks to do quite well this summer is because the stocks themselves still have lots of room to run.
Take a look at the chart below. This chart is for the iShares Russell 2000 ETF (IWM), a good proxy for small cap stocks in the U.S.
As you can see, there’s still a lot of room left for small cap stocks to run before getting close to the highs from last year.
This is important because stocks often take a bit of a pause when trading close to previous highs. (That’s exactly what we’re seeing in the broad market for blue chip stocks right now). Investors can be more likely to sell when markets initially hit new highs because they’re worried about a pullback.
But for small cap stocks, we’ve got a long way to go before we get to that point.
So with the Fed and President Trump creating some new challenges for blue chip stocks this week, now is a great time to shift your focus to stocks of smaller businesses with operations here in the United States.
A good place to start is buying IWM pictured above. And from there, I’d recommend looking at American retail, American energy, and smaller American banks with strong earnings and loyal customers.
Don’t let a few days of market weakness get you discouraged. Instead, look for the areas that are showing strength, and move some of your investment capital to take advantage of those opportunities!
Here’s to growing and protecting your wealth!