Stock Investing: Signals To Buy & Sell
How To Identify The Telltale Danger Signs…
Unfortunately, the statistics reflecting small stocks' long-term superiority over large shares also mask one other critical fact:
During times of slow growth and moderate inflation, investors are more focused on safety and opt for more reliable earnings in the growth of big companies. As a result, small stocks’ underperform.
When inflation is falling while economic growth is slow, competition intensifies for ever-smaller markets. Companies focus more on increasing their share of a shrinking marketplace than on boosting sales from newer sources. Big companies entrenched market positions and larger bank accounts give them a huge advantage. They can absorb economic shocks more easily, while reducing prices advantageously to cut out their competition.
Unless the products of a small company have a clearly defined and growing niche market, small companies can be cut out of the picture during recessions. Why? Because big companies have the capitalization to exponentially ramp up sales by expanding their market share. Even if a small company does have a niche market, they could suffer in the event that customers consider their products non-essential.
In a slow growth economy, it's very hard for small companies to thrive. Our first table, labeled “Inflation is the Key” shows how small stocks fare poorly during slow growth environments. Whenever inflation has been falling, small stocks’ have under-performed large stocks.
INFLATION IS THE KEY
History provides evidence that during full fledged recessions, the gap has widened even more. During the 1972 to 1974 sell-off, large stocks lost on average 35%, as measured by the S&P 400 Industrial average.
That was bad. However, far worse was the catastrophic near 50% loss suffered by the smallest 1/5th of the New York Stock Exchange between February 1972 and December 1974. Many small companies went bankrupt during those years. Likewise, those who did survive, the averages of very small stocks’ lost an astounding 90% of their value.
Much higher inflation in the years ahead is an extremely bullish signal for small company stocks, whose profits’ will likely be greater as the economy moves towards its’ peaks.
Unfortunately, the inevitable valleys we hit will almost certainly wipe out all but the strongest small companies, just as they've done during past inflationary periods.
When considering a signal to buy; timing your entry into small cap stocks’ is even more important than with big cap stocks’.
We have two simple rules for reaping the profits while avoiding pitfalls…
Signal #1
Buy small stocks whenever the annual rate of growth in the CPI rises above 7%
Signal #2
Sell small stocks or stand aside when the CPI growth rate falls below 4.5%
And, of course, as indicated in our previous blog, The Power of Small Stock Investing, switch into big stocks when the PPI drops below 4.25%.
Following these key signals is a historically proven formula for success during inflationary times.
History serves as a measure to anticipate similar future scenarios, helping all who keenly observe to see way ahead of the curve. A perfect example of a relevant financial historical reference mirroring today’s economic climate dates back to April of 1973. CPI growth moved above 7%, obviously triggering a buy signal.
The CPI stayed above 5% for nearly a decade, until November of 1982. During that time period, the average small cap stock scored almost a sevenfold advance… The average annualized gain of 22.6% is amongst the highest long-term returns for any investment ever!
That's in sharp contrast to the flat returns on big cap stocks.
Perhaps the most remarkable time period was between mid-1976 and mid-1982. During those six years the Dow fell from about 1,000 to 780. As a result, it was a period largely regarded as terrible for almost all big cap stocks, especially with inflation averaging over 9% per year.
Such was not the case for investors that focused on small cap stocks. During those 6 years- the average small stock shares (the smallest 20% of the NYSE) returned an average of over 24% per year. Had you bought the typical small stock, you would have nearly quadrupled your money during those six years.
As a general rule of thumb; when inflation is rising, your portfolio should be weighted toward small stocks’. When inflation is low and simultaneously falling, big stocks’ are the best bet.
There will be times when inflation is rising so fast that it must be tempered. When the Federal Reserve is forced to stamp its foot on the fiscal brakes to prevent a financial hyperinflationary meltdown, small stocks will be amongst the worst possible investments you can own… You'll want to be long gone!
That's why we've added one additional signal for investing in small stocks:
Sell if the annualized growth rate of the PPI rises above 15%
Should PPI inflation reach that neighborhood, the FED will be forced to take some kind of drastic deflationary action. As the Fed reverses course into QT- quantitative easing- a recession will be unavoidable. A harsh bear market for small stocks will follow.
As long as inflation remains in a long term uptrend, small stocks’ will out-perform big stocks mightily when the market recovers. Once stocks do hit bottom, you'll want to load up on small stocks’, not big ones.
Stay tuned for next week's article featuring “Small Stock Shopping Tips”
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