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To Outperform the General Market, Keep Your Eye on Small Caps


Small caps have historically outperformed large caps in a rising rate environment.

The white-tailed hornet lives in a balloon
That floats against the ceiling of the woodshed.

– Robert Frost

"Up, Up and Away," recorded by hundreds since its 1967 debut, seems to be the welcoming ballad for the 2013 US equity markets. The first week's action brought the S&P 500 (INDEXSP:.INX) and the Russell 2000 (INDEXRUSSELL:RUT) to the highest closing levels in five years. As a matter of fact, the Russell 2000 exploded into an all-time high as it surpassed its 2011 and 2007 highs. Is it time for the small-caps to shine?

Over the last week there has been a plethora of economic and Federal Reserve news which has begun to surface from between the cracks of the incessant discussions of the fiscal cliff, the debt ceiling, and looming sequestration. Foremost is the talk of ending QE Infinity in 2013, not the anticipated end of 2014. This talk drove the 10-year yield to levels not seen since last May -- 1.92%. Technically speaking this will not become an overwhelming issue until the 2011 (1.5 year) level is broken around 2.4%. However, even a retest of the 2.4% resistance would be a ~25% move higher in yields.

With July 2012's all-time low on the 10-year yield at the front of investors' minds, the talk has turned to a potential "permanent" bottom and a possible break of the 31-year downtrend (since 1981). In my humble opinion, there continues to be too much uncertainty to make that type of call. but the cards are beginning to fall in place and build a foundation for this argument. For now it looks as if 3.75% would be the beginning of the end.

So why the 10-year discussion when asking about small-caps? Simple -- small-caps have historically outperformed large-caps in a rising rate environment, especially at the onset of GDP expansion from a slowing or lackluster environment. This, of course, assumes the market in general will continue its rise through the resistance points, and the Dow Jones Industrial Average (INDEXDJX:.DJI) and the Nasdaq 100 Index (INDEXNASDAQ:NDX) follow suit.

The actual underlying point of this missive is the following: If you believe the hornet will allow the balloon to continue its flight and are looking to outperform the general market, small-caps may be your answer.

I hope helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
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No positions in stocks mentioned.

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