The stock market continues to gyrate based on responses to earnings news and Federal Reserve policy statements and follow-up speeches. As a result, short periods of volatile trading may become more common over the next few weeks. However, the general trend for stocks remains on an upward trajectory, as I’ve noted here many times.

The Uptrend Remains Intact

The nearly 20% run in the S&P 500 (SPX) from the October 2022 market bottom has suddenly become hot news. Luckily, here at Investing Daily, we’ve been bullish on stocks since the early days in the trend, as far back as October 2022, with wide ranging articles on what to expect in 2023, especially if the historical tendencies of the stock market to rally in the third year of the Presidential Cycle asserted themselves once again.

WATCH THIS VIDEO: Lasting Rally or Another Head Fake?

A quick review is in order. The Presidential Cycle is a repeating four-year cycle in which the Federal Reserve tends to raise interest rates in the first two years while lowering rates in the third and fourth year. This often translates to a very big year in stocks in year three, with usually a less profitable but fairly good year four following.

And while large-cap companies often get all the press, there are instances in which smaller stocks provide a fertile field of opportunities to make money. The current uptrend may be one of them.

Small Cap Primer

Generally speaking, small-cap stocks are defined as those of companies whose market share value is anywhere between $300 million and $2 billion. Below $300 million is the micro-cap universe. Stocks whose market value is above the $2 billion mark are in the mid-cap group.

At any time, there may be somewhere around 2,000 small stocks in an average market. This number may decrease in bull markets as companies gain in market value, while the number may increase during bear markets when share prices fall.

The most popular gauges for small cap stocks are the Russell 2000 and the S&P Small Cap 600 index (SML). The two indexes tend to follow the same general trends and often deliver similar results.

I prefer the S&P Small Cap Index as a bellwether, because the number of stocks is representative of the most important stocks in this area of the market. Also, as I discuss below, there’s a highly useful exchange-traded fund (ETF) that mirrors this index quite closely.

Perhaps the most attractive characteristic of small-cap stocks is that when they are in a bullish trend, they tend to outperform blue chip stocks. The down side is that there are market periods when small caps don’t participate in uptrends. Another negative is their prices tend to be more volatile.

As a result, it’s imperative to be choosy when one decides to put money to work in small stocks.

2023’s Stealth Bull Market in Small Stocks

The stock market uptrend that started in October 2022 has been very good to small-cap investors. Consider the difference in gains for the major indexes from the October 2022 market bottom to the present:

• Dow Jones Industrial Average: +21%
• S&P Small Cap 600: + 24.5%
• S&P 500: +20%
• NASDAQ Composite: +17%

Certainly, the rally off of the October bottom has lifted most sectors of the market. However, the S&P Small Cap 600 is up nearly 15% in 2023 while the DJIA is up roughly 3%. This clearly suggests that more money is moving into small-cap stocks than into blue chips at the moment.

The reason is twofold. First, small caps tend to grow faster than blue chip stocks. That attracts money from growth investors. Second, and perhaps more interesting from a macro standpoint, small-cap stocks tend to serve domestic markets while blue chip stocks are the shares of large multinational companies. Moreover, large multinationals do a lot of business in China, where geopolitical tensions and the until recently in place COVID lockdowns have hampered corporate results.

In other words, if the U.S. and China’s geopolitical tensions continue to rise, investors will be looking to put their money to work closer to home. And this favors small-cap stocks.

ETFs and Selected Stocks Offer Opportunity

Because it’s often difficult to find that diamond in the rough in the small-cap universe, ETFs may be the answer for the average investor.

One of my favorite small-cap ETFs is the iShares Core S&P Small Cap ETF (IJR). It’s considered the most liquid small-cap ETF and it caters to active traders. I like it because it focuses on the best stocks in the S&P 500 Small Cap 600 index.

This relatively small number of stocks gives the index a much better correlation to what’s going on in the market. In addition, it’s been around since the year 2000, which gives it a rich history from which to mine data about how the fund does during different types of market periods.

IJR is up nearly 26% since the October 2022 bottom and up 13.7% for 2023.

Individual small-cap stocks can often generate surprising gains. Take mobile homebuilder Skyline Champion (NYSE: SKY), a stock which just a few months ago had a market cap below $3 billion. The stock has quietly been building up a head of steam and on 2/7/23 popped in a big way, on no discernible news.

SKY is a perfect example of how it pays to dig deeper into strong sectors such as the homebuilders to mine for potential diamonds. That’s because even as other homebuilders rallied over the last few months, these shares lagged.

On the other hand, technical indicators such as Accumulation Distribution Indicator (ADI) and On Balance Volume (OBV) were rising. A rise in ADI is an excellent sign that short sellers are getting out. A rise in OBV means that buyers are coming in. When both ADI and OBV converge, it’s a sign that a stock is getting ready to move higher.

Bottom Line

The year 2023 may be an time to invest in smaller companies. That’s because they are still being overlooked by many investors. Moreover, small companies often offer better growth prospects than blue chip or large-cap stocks.

Finally, because small companies tend to serve domestic markets, geopolitical tensions and general macro trends such as nearshoring may make these companies more attractive.

Editor’s Note: In a new report, our colleague Dr. Joe Duarte pinpoints a groundbreaking tech disruption worth $75 trillion…and it all starts with one small-cap stock that’s getting ignored by Wall Street.

Dr. Duarte is the chief investment strategist of our premium trading services, Profit Catalyst Alert and Weekly Cash Machine. He currently recommends a “small fry” opportunity that’s poised for big gains. Learn more by clicking here.