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The Russell 2000 has had a powerful November — and the gains aren’t over

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Smidcap stocks are on fire. The Russell 2000
RUT,
-0.31%

is up over 19% this month compared to 10% for the S&P 500 index
SPX,
-0.08%
.

Will it continue? This group has been beaten and battered for so long that many people simply doubt the move. But this is a big mistake. I don’t know about the next few days ahead, but smidcaps will continue to do well over the next year for the following five reasons.

By next June the economy will be really hot. The debate then will be about inflation and whether the Federal Reserve needs to “take away the punch bowl” to contain prices. The reason: Politicians and the Fed have dumped the most stimulus on the economy ever relative to GDP. They’ve deployed more than even during either the 2008 financial crisis and World War II, when war spending served as de facto stimulus.

It’s a no-brainer that this will create rapid growth and inflation as the COVID-19 virus recedes as a problem.

This is an ideal environment for midcaps, defined as companies with a stock-market value of $2 billion to $10 billion, and small-caps ($300 million to $2 billion in market capitalization).

That’s because smaller companies run lean compared to large companies. So when prices go up, more of the gain falls to the bottom line. “Small companies have greater operating leverage so their profits grow faster,” says Jim Paulsen, market strategist and economist at the Leuthold Group. “Historically small companies have done a lot better compared to large companies when inflation goes northward. We prefer small to large amid expectations for a strong U.S. economic recovery.”

Already, earnings estimates for the S&P 600 are going up faster than estimates for S&P 500 companies. This trend will continue.

No. 2: A lot of investors still don’t believe

Many people just aren’t buying it. Lance Roberts, chief strategist at RIA Advisors, questioned the small-cap run on Twitter on Wednesday.

He is not alone. But this is actually bullish. It means there are more non-believers out there to come on board and buy your smidcap stocks, pushing prices higher.

“Small-caps are woefully underrepresented in most portfolios,” says Paulsen. “They have been doing so poorly for so long, many investors have favored the winners in large-cap.” As the rotation into small cap continues, “you will get more and more people lifting their exposure. This will add fuel to leadership cycle,” he says.

No. 3: Smidcaps are relatively cheap

This reflects the fact that they’ve been persistently unpopular, despite the recent gains. “Their price action has not kept up with earnings performance,” says Paulsen. Since the end of October, forward one-year estimates for the S&P 600 small-caps have gone up almost 8%, compared to 1.5% for the S&P 500.

In other words, earnings estimates have gone up over four times as much, but stock prices have only gone up twice as much.

From their lows during May-June, the forward earnings of the S&P 500 grew 17%, compared to 35% for the S&P 400 smidcap stocks and 57% for S&P 600 small-caps, according to Ed Yardeni of Yardeni Research.

As of Nov. 24, large-cap S&P 500 stocks had a forward price earnings ratio of 22 compared to 19.7 for S&P 400 midcap stocks and 19.9 for S&P 600 small-cap stocks, says Yardeni. But the gap is effectively wider, given the greater potential for earnings growth among smidcaps going forward.

The bottom line: small-cap stocks have additional catch-up potential.

No. 4: Small-caps have stealth international exposure

One ding on smidcaps is that they are mainly domestic companies with little exposure to global growth. That would be a bad thing, since developing world growth will outdo U.S. growth going forward. This expansion cycle will keep boosting commodity prices, and the economies of many developing countries are commodity-based. Plus governments around the world have injected massive amounts of stimulus into their economies.

But small companies have a lot more exposure to international growth than people think. One sell-side shop puts the earnings exposure at 20%. But it is probably higher, says Paulsen. This is because a lot of small-cap companies supply larger U.S. companies that do a tremendous amount of business overseas.

“To the extent that overseas activity picks up, small-caps will notice an increase in their business,” he says.

No. 5: Market participation will continue to broaden out

When Pfizer
PFE,
-0.41%

 released very positive vaccine news earlier this month, “everybody came to the same conclusion at the same nanosecond that the market would broaden out,” says Yardeni. The same thing happened when Moderna
MRNA,
+9.37%

 released good vaccine news a few days later.

This explains a lot of the recent smidcap outperformance. “All the laggards are leaders right now,” says Yardeni. But he thinks we are only at the beginning of this trend, when you consider how extended the largest S&P 500 companies were compared to the rest of the index.

“The market seems to broaden when we get vaccine news. Over the next six months as vaccines roll out the market will continue to broaden and favor smidcaps and value stocks,” he says.

How to play this

The best way to play this is to favor those small-caps most sensitive to the economic cycle, meaning groups like technology, banks, energy and industrials. That way you get a two-for-one, because cyclicals tend to outperform defensive plays as growth picks up.

One problem here is that a lot of people have come around to this view, so it is no longer out of consensus. I’ve been favoring cyclicals in my stock letter (link below in bio), and in my column since March — see here, here, here and here .

The easy money has been made, but there is more to go.

One good way to get diversified smidcap exposure is by purchasing exchange-traded funds like the iShares Russell 2000 ETF
IWM,
-0.12%
,
Invesco S&P small-cap Information Tech ETF
PSCT,
+0.04%
,
iShares Core S&P Small-Cap ETF
IJR,
-0.53%
,
Invesco S&P 500 Equal Weighted Industrials ETF
RGI,
-0.74%

and iShares Micro-Cap ETF
IWC,
+0.31%
.

Equal-weighted ETFs give you more exposure to smaller-cap companies than market-cap-weighted ETFs.

Next, small-caps require more research than large-caps because they have less coverage by Wall Street analysts. So the transition to smidcaps may favor managers of active mutual funds.

In my stock letter, I’ve recently suggested cyclicals like Covenant Logistics Group
CVLG,
+0.10%

 in trucking, Live Oak Bancshares
LOB,
-2.20%

 and B. Riley Financial
RILY,
+3.55%

in banking and finance, and Continental Resources
CLR,
+0.88%

in energy. They have done well and while they might cool off near term, they should do well in the continuing rotation to smidcaps.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned LOB, RILY and CLR. Brush has suggested CVLG, LOB, RILY and CLR in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.





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‘I could live on my Social Security and still save money’: This 66-year-old left Chicago for ‘calming’ Costa Rica — where he now plans to live indefinitely

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Editor’s note: This article was first published in September 2019.

A school break changed 66-year-old Martin Farber’s life forever.

In 2007, his daughter — who at the time was attending Illinois State University — decided she wanted to spend a college holiday volunteering in Costa Rica and staying with a local family, he explains. She came home raving about the experience, so, in 2008, Farber — who at the time was living in Evanston, Ill., just outside Chicago, and selling cars — took his first trip there.

“It was a big surprise to me — bumpy roads, dogs barking in the streets,” he says. “I wasn’t enamored at first.”

But as his daughter began traveling there more and eventually moved there for a year, he took additional trips to Costa Rica. It quickly grew on him — in particular, the people. “The Costa Rican people are warm, open and friendly. I felt less invisible in a strange country in a strange town where I didn’t speak the language than I did in Evanston.”

And the more time he spent there, the more it impacted him: “On one of my trips there, I thought: My daughter’s life makes more sense than mine,” he says. “There was nothing wrong with my life, but I felt that my life was out of context with who I’d become. … I would have bills and make money to pay them, but that had ceased to be satisfying,” he recalls. “I knew I needed to change my life — there was no more joy in what I was doing.”

What’s more, when he’d return from his Costa Rica trips, people noticed. “I would come back, and my friends and therapist would say: You seem better after you go,” he says with a laugh.

A view from the hot springs near Martin Farber’s home in Costa Rica.


Martin Farber

So in 2014, he packed up and moved to Orosi — a picturesque, lush small town with waterfalls and hot springs a little over an hour’s drive from San Jose — promising himself he’d stay for two years. It’s been five, and he now plans to stay in Costa Rica indefinitely. (Though Farber notes that, to him, “it’s not a retirement; it’s a chance to lead a new and different life.”)

Here’s what his life is like, from costs to health care to residency to everyday life:

The cost: While many expats spend way more living in Costa Rica, Farber says: “I could live on my Social Security and still save money.” He says “a person can live on $1,200 per month, two people on $2,000.” The key, he says, is to live more like he does and as the Costa Ricans do — in a modest home, eating local food and purchasing local goods.

Indeed, Farber himself spends just $300 a month for rent (he rents a home from a friend who moved recently and gave him a good deal), roughly $225 a month on groceries and just $50 a month total on water and electricity (the temperate climate in Orosi means you rarely need heat or air conditioning). The veteran Volkswagen
VOW,
+0.96%

 
VLKAF,
+0.98%

salesman saves money by not owning a car (those over 65 ride municipal buses for free), which can be a significant expense in Costa Rica; for his cellphone, “I pay as I go … roughly $10 may last me a couple weeks or more,” he says, adding that “many people handle there their cellphones this way. You can get them recharged anywhere.”

His major expense is travel: He goes back to the U.S. to visit his mother in Florida several times a year and lately has spent part of the summer in Chicago helping out a friend with a dealership there. He also spends a good amount of money on health care. He says that while flights can be had for as little as $350 roundtrip during offseasons, the cost can be much higher the rest of the year.

In the saddle.


Martin Farber

Health care: Farber, who has permanent resident status in Costa Rica, says he pays about $90 per month to participate in the country’s health-care system — adding that the health care he’s received has been very good. (A 2018 study of health-care quality and access in more than 190 nations ranked Costa Rica No. 62.)

When he developed a detached retina, though, he paid for the procedure out of pocket so that he didn’t have to wait for the required surgery, he says — adding that the entire procedure cost him about $5,000. “I would have had to have waited four days,” he says, if he had not paid to expedite matters. “That might have been fine, but it might not.” And he adds that the quality of care depends on where you get it in the country.

Lifestyle: Though Farber says that he “moved here with no goals and no agenda,” he’s found plenty to do. “I take Spanish lessons two days a week for two hours a day. It’s been great. I never thought I would acquire a usable language in my 60s,” he says. He also rides his bike all around the area, does some writing and belongs to a community group that undertakes projects to improve the area.

And he often simply takes in nature, which he says has been an essential part of why he feels calmer and more relaxed in Costa Rica than in the U.S. “I live at 3,000 feet but in a valley surrounded by coffee fields and lime trees and water. At night, if I open the windows, I can hear the river rushing by,” he says. “It is very calming … hundreds of trees everywhere … you know the Earth is alive.”

The historic Iglesia de San José de Orosi.


iStock

Cons: “I don’t want to overglorify. It’s not without its problems,” Farber says of Costa Rica. “There are social problems and downsides.” He notes that crime and petty theft can be a problem (“I am cautious,” he says of his approach) and seem to have increased since he moved there, and adds that he misses out on some cultural things because of where he lives. And, he says with a laugh, “I can’t order Thai food at 9 at night.” But, he adds: “These are trade-offs — in the afternoon, I get to walk in the coffee fields and see flocks of parrots.”

Residency: To qualify for Costa Rica’s pensionado visa, expats must prove that they have a pension of at least $1,000 coming in each month. (Here are the details of that program.) Once you have lived in Costa Rica for three years, you can apply for permanent residency. Farber used a lawyer to help him figure out the ins and outs of residency options; his entire path to permanent residency took about a year, he says.

The bottom line: “After five years I am still amazed and surprised that I made the decision to lead a life I never thought I would,” he says. And while he may not stay in Orosi forever — “the town doesn’t have an ambulance, [and] I don’t know what it will be like to be 80 there,” he says — he does plan to stay in Costa Rica in no small part because of the people and sense of community. “I have the feeling that life is good here,” he says. “It’s hard sometimes, but we are all in it together.”



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Mutual Funds Weekly: These money and investing tips can help you read the market’s signs and stay on your path

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