Invest in Assets

Small Cap Stocks During Recession: Recipe For Disaster?

If you’ve read a single thing related to the big-picture economy in the past year or two, chances are rather good you’ve heard rumblings of the supposedly looming recession. While that still hasn’t quite materialized, the only thing less likely than any of these individual predictions is the idea that we’ll never have another recession.

In other words, while it’s still the case that no one really knows when the next recession will be, it’s safe to assume there will be another one eventually.

This begs the question: if you invest in small-cap stocks, should you continue to do so during a recession? Or is that recipe for disaster? Wouldn’t it be smarter to invest in more “dependable” companies?

To answer that question, we’ll consider small-cap performance today, historical performance, and overall portfolio strategy. And, in this article, we’ll assume you are investing primarily with a buy-and-hold strategy.

Small-Cap Performance Today

If you see headlines such as CNBC’s article, “Small cap stocks are tanking, while large caps hold up,” you might be tempted to sell any small-cap stocks you currently have. One thing we have to remember, though, is that all stocks experience some degree of volatility. If stocks never fell in value, they would probably net 2% (or lower) returns.

The fact that stocks are volatile is why we earn a return on them. No risk, no reward.

The above is not the only article that shows bad signs for small-cap today. For example, MarketWatch reported several bearish statistics on them. This includes small-cap stocks declining 10% from their August, 2019 highs. In addition, analysts have lowered their first quarter forecasts by 13.5% since the end of 2018.

One thing I do appreciate with this particular article, though, is the author mentions what negative growth for small-cap stocks means for the broader market.

Because it isn’t necessarily the case that small-cap is on its way out, and that is why it’s struggling. Instead, there can be – and likely are – bigger-picture factors that are leading to this negative growth in recent quarters.

The ongoing trade war with China is certainly something to consider. Trade wars often lead to recessions, and this one is, at the very least, is causing some drag on the economy.

But despite CNBC’s and MarketWatch’s negative headlines from earlier in the year, things are far from terrible for small-cap stocks today. Articles from sites such as Barrons and Royce Funds show that small-cap stocks lately are either treading water or, as in September 2019, doing quite well.

The thing here is that in the short term, things can change rather quickly. And that’s exactly why acting on an impulse isn’t necessarily a great move. If you are investing for the long-term, the noise of today simply doesn’t matter.

Small-Cap Historical Performance

Regardless of any biases some may have against small-cap stocks, the numbers don’t lie. And the numbers work pretty well in their favor (in most cases).

Although the article is old now, Paul Merriman wrote about this very topic back in 2013 for MarketWatch. The most important thing from this article is the table that shows decade-by-decade data as well as average annual returns for 1930-2013.

It doesn’t take long to notice that small-cap value beats the S&P 500 most of the time. It beat the S&P by almost 5% during 1930-2013. 5% is a massive percentage!

The only decade in this table where small-cap value experienced a negative return was 1930-1939 – an era plagued by the Great Depression.

Interestingly, although the S&P 500 was barely down in that decade, large-cap value actually fared much worse than small-cap value. This is why blanket statements, such as “small-cap stocks are more volatile” are not always accurate.

Plus, if we are using a buy-and-hold strategy, one year is irrelevant. Really, even one decade doesn’t make or break an asset class.

Does Market Performance Really Matter?

You might think market performance should have a large – or at least a moderate – impact on your investing strategy. After all, who wants to invest in assets that are a major drag due to poor market conditions?

But, again, these are the wrong questions to ask if we are investing for the long haul.

If you are doing some form of day trading, including dividend stocks, then short-term market performance is obviously a big factor. Long-term market performance? Less so when day trading.

But the reverse is true with a buy-and-hold strategy: short-term market performance is nearly irrelevant, while long-term market performance is immensely important.

And recall the table in the Paul Merriman article mentioned above. Although the 1930s reflected negative growth of small-cap stocks, no other decades did.

It’s not as though the Great Depression is the only time the US experienced economic turmoil. There have been many recessions in the United States; even since the Great Depression, there have been about 13 of them.

And yet, throughout all of those recessions, small-cap value beat the S&P over most decades. It’s not that market performance doesn’t matter, but what’s most important is your investing strategy.

No one likes to see their portfolio decline in value, but what your portfolio does today, tomorrow, and even this year doesn’t matter so much. It’s how it looks 10, 20, and 30 years from now that concerns us.

Is a Recession Imminent?

Of course, I don’t have the answer to that question. But we’ve been hearing for months and months now that a recession is right around the corner. While economic growth isn’t exactly explosive, there are also few signs that the wheels are about to come off.

According to the Chicago Fed, economic growth in 2019 is expected to be 2.3%, with a 1.9% figure forecasted for 2020. No, these numbers aren’t exactly impressive, but they aren’t cause for major concern, either.

After all, the definition of a recession is (at least) two consecutive quarters of negative growth. An economic slowdown is not the same thing as negative growth – a territory we have still yet to enter.

The reality is that no one knows when the next recession will ultimately strike. We can say with almost absolute certainty that there will be one, but when? My guess is as good as any.

However, if you are a buy-and-hold investor, even recessions aren’t that big a deal. Why? Well, despite the dozens of recessions our economy has endured, the economy has always recovered – and then grown larger than it was before that recession.

Invest Based on Your Goals, Not Based on the Market

It’s easy to get caught up in all the craziness that happens on a day-to-day basis in the market. Things change at a breakneck pace. The problem that can cause is so many people react and make decisions based on emotion.

While we all experience emotions, and it’s quite difficult to totally stop them from influencing our behavior, it’s usually preferable to limit such reactionary decision-making.

Instead, determine how you want to invest: will you be more of a day trader, or would you rather buy and hold, then invest for decades to come?

These are the questions you need to ask, then adjust your strategy depending on the answer. Ignore the rest. The more you pay attention to the noise, the more liable you are to getting off track.

So, what kind of investor do you want to be? That’s up to you to figure out.

Leave a Comment