I love investing in small companies.

As I wrote last week, smaller stocks tend to outperform larger stocks over time. And the effect is even stronger when combined with the other five main factors that drive my stock power rating system: momentum, volatility, growth, value and quality.

But I also know that markets often go in cycles. Certain sectors of the market perform better or worse depending on how things are going in the economy and what is happening at the macro level.

This year has not been good for small-cap stocks. The S&P 500 is down about 16% over the past 12 months. But the small-cap Russell 2000 is down more than 23% over the same period.

It’s not hard to see why:

1. Smaller companies are more sensitive to Federal Reserve policy. As the Fed drains liquidity from the market, capital becomes scarcer and smaller companies see their funding costs rise as they have less bargaining power and less market influence than their larger peers.
2. Small-cap stocks often rise. These stocks suffer when the Fed raises interest rates because investors buy them based on expected returns years or even decades into the future. Those future earnings are worth less and less as rates rise in current dollars.
3. Smaller companies are often more vulnerable to economic downturns. The yield curve has been inverted for most of this year, which bodes well for a recession. The data, though mixed, point to tough times ahead. Even Amazon.com is the mighty Amazon! — hinted in Thursday’s earnings call that holiday spending may be lower this year.

All this contributed to a difficult year experienced by small caps.

And now for some good news for small-cap stocks!

Crush the small caps everything otherwise out of recession.

All the factors that harm them in hard times reverse and strengthen them when the scenario is reversed. Financing costs are falling, interest rates are falling, and the economic downturn is turning into growth again.

Bear markets “reset the clock” so to speak, driving down valuations to a level that supports a prolonged bull market. Last year’s carnage sent the Russell 2000’s forward price-to-earnings ratio down to just 13. That’s the lowest since the 2008-2009 bear market.

Historical precedents are also good.

Prudential Securities measured the performance of the 20% of the worst-performing stocks against the S&P 500 index that emerged from the recession. After all recessions since 1953, small-cap stocks have outperformed the S&P 500 by an average of 34% to 18% in the post-recession year.

But I want to pay particular attention to the bear market and recession of 1973-1974 because I think it is most relevant to the world today. Then, as now, the crisis followed a prolonged technological boom. Rapidly rising inflation and significant changes in Fed policy were also features of both.

Well, getting out of that recession was a nasty one! — small caps beat the S&P 500 by 20 points, 58% to 38%!

And just for giggles, let’s also include the 1980 recession, since that marked the end of another inflationary era. Since the recession, small-caps have performed even more, undercutting the S&P 500 by 32 points, from 45% to 13%.

There’s no guarantee that small-cap stocks will repeat that performance this time around. But history is on our side.

We may still be in a bit of pain in the current bear market, and a few more quarters of below-par GDP growth wouldn’t surprise me.

But when the time is right, we’ll want to focus our investments in the areas that are most likely to do better, and that includes small caps!

The size ratio of my own rating system helps me identify stocks that are big enough to benefit from this move. Combine that with my five powerful factors and it’s a powerful combination that creates opportunities for outsized profits.

And we just added new small cap stocks Fortunes Green Zone portfolio. This company is taking advantage of the growing demand in the healthcare sector and has grown by 16% in just two weeks!

This is the size factor in action. If you would like to access this recommendation alongside a model portfolio targeting the market’s biggest megatrends, click here to watch my ‘Imperium’ presentation to learn how to join.

I can’t wait to help you weather this bear market and set your portfolio up for huge success when things turn around.

Until next time.

To good profits,

Adam O’Dell

Chief Investment Strategist