Small Cap Stocks – A Warning Signal For The Market

Businessman, Internet, Continents

Since March 2020 the small cap stocks (IWM) more than doubled. IWM appreciated almost eight times since 2009. But IWM does not go up on a straight line. There are times it appreciates rapidly. Other times it pauses for as long as one to two years. 

The purpose of this article is to discuss its relationship with the business cycle and find out what are the periods IWM is particularly attractive as an investment.

Source: The Peter Dag Portfolio Strategy and Management

There are two distinct periods in a business cycle. The first one is the period the business cycle rises, reflecting an expanding economy. This period includes Phase 1 and Phase 2.

The second one takes place when the economy weakens, and the business cycle declines. This period is characterized by Phase 3 and Phase 4.

During Phase 1 and Phase 2 business finds out demand is growing, and inventories need to be replenished.  Raw materials must be purchased. Workers need to be hired. Money needs to be borrowed to finance increased production and improve capacity.

The outcome is rising commodity prices, rising wages, and rising interest rates. The rise in wages further increases demand, forcing business to increase production. It is a virtuous cycle (positive feedback), stimulating growth. But accelerating growth cannot last forever.

Toward the end of Phase 2 the rise in production costs, the rise in inflation, and the rise in interest rates has a negative impact on consumers’ purchasing power. The outcome is a slowdown in sales.

In Phase 3 business finally recognizes inventory is accumulating because of slower demand. This is the time production and costs are cut aggressively. The result is a decline in purchases of commodities, reduction of the labor force with resulting declining needs for borrowing. Sales continue to slow down. 

These activities feed on themselves (negative feedback) forcing business to become cautious about its business and production plans.

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Disclosure: Check out The Peter Dag Portfolio Strategy and Management on www.peterdag.com. An ...

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