A Case for Small Caps, in One Chart

Early last month we warned that small-cap stocks were ripe for a pullback. Valuation metrics and technical indicators flashed red flags that the Russell 2000 index had gotten overly extended, and that a pullback was needed before small stocks could continue rallying.

Sure enough, the small-cap index slumped 8% in a month amid a selloff that brought down the so-called momentum stocks that had been soaring higher and higher for much of the previous year.  Small caps were caught up in the selloff as the high-flyers–including social-media companies, cloud-computing firms and early stage drug producers–came back to earth.

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But the Russell rebounded 2.4% last week amid a broad-market rally. And now, some market watchers suggest small caps could be poised for even better times ahead.

In a white paper, portfolio managers at Deutsche As(DBK.XE)set and Wealth Management make the case for investing in global small- and mid-cap stocks for a longer time horizon. Historical performance backs up their thesis: Since 1926, small-cap stocks have outperformed large caps by 2.38% annually as of Dec. 31, according to data compiled by Deutsche.

Smaller stocks tend to outpace their larger brethren mainly because small caps are more isolated to global economic troubles than multinational firms. They tend to be more thinly traded, which can exacerbate their price swings in either direction. The Russell is up 232% from the March 2009 low, compared to a 175% rally for the S&P 500 and a 150% gain for the Dow Jones Industrial Average.

Even after the big rally over the past five years, Deutsche is still bullish on small caps, primarily because of their positive long-term track record. As the chart below shows, small-cap stocks have had a positive performance over every rolling 10-year period since June 1930, the firm says.

Click for bigger image Deutsche Asset & Wealth Management

In 2014, the Russell 2000 is down 2.2% year-to-date, whereas the S&P 500 is up 0.9%. But over the past 12 months, the Russell is up 26%, while the S&P 500 is up 21%.

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“We believe after three years the performance potential of small-cap stocks may outweigh their volatility,” Deutsche said in the white paper. “Therefore, in our opinion, investors with time horizons of greater than three years may wish to consider allocating a portion of their equity portfolios to small-cap stocks.”