Primer On Small Cap Investing And Why Goldman's Research On It ...

Investors have been pretty happy lately because the US stock markets is up about 10 percent for the year through March. Since investors are happy, their overall level of investing fear is pretty low.

We know this because there is an index we use to gauge investor fear, and that index is down about 30 percent for the year through March. The fear gauge, the VIX, is down, indicating that investors aren?t very fearful right now.

According to Barron?s, Goldman Sachs believes that when we go through periods of low fear, like right now, small capitalization stocks tend to do well shortly after this decline in the fear gauge. Small cap stocks are ?small? companies,?measured by their stock price and number of stocks outstanding.?

Specifically, Goldman?s research shows that some small capitalization stocks outperform large capitalization stocks?by a median annualized 8.1 percent in quarters that follow especially rapid declines in the VIX index. Large cap stocks are like what you?d find in an?S&P index fund, that index consists of?large companies.

And then they go on to provide a fancy chart to support their claim that when the fear gauge is low, this provides a good tailwind for small cap stocks. Here?s their chart, forget about the fact that the chart is missing some key information, we?ll get to that in a second.

Here?s what you need to know:

This is the part that Barron?s (or Goldman) forgot to include: Small capitalization stocks generally lose more money when things are bad and make a lot more money when things are good.?They?re small companies, less robust, and so they?re more sensitive to the market environment.

And this is why Goldman left out 2001, 2007 and 2008, in their fancy chart. Years when the fear gauge (the VIX) spiked, and small capitalization stocks sucked wind. This is coincidentally the most important thing to understand with small capitalization stock fund investing.

So where are the years 2001, 2002, 2007, and 2008 in this chart?

They left those out because:

1) Fear (or the VIX) spiked those years.

2) And small capitalization stocks tanked.

If the fear gauge is low like it is now, that?s not a reason to buy small cap stocks.

You buy small capitalization stock funds if you believe:

1) They?re undervalued. PS no mention of this in the Barrons article?

and/or

2) You believe that the stock market is going increase. And, you?re willing to take the risk that if the market goes down, you?ll lose more than you would in large capitalization stocks.

Just because volatility is low doesn?t mean small caps are going to outperform large caps.?That?s the whole ?correlation does not equal causation? thing people talk about. If two things are somewhat correlated it doesn?t mean that one causes the other (in this case, the low fear gauge (VIX) does not cause small cap stocks to do well, even though the Goldman research wants you to believe that).

(Barron?s)

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Source: http://makinsensebabe.com/primer-on-small-cap-investing-and-why-goldmans-research-on-it-doesnt-make-sense/

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