Fighting a Bear Market Mindset

Financial discourse in this country has been slow to switch gears.

Even as the broad market recovered sharply to begin the year — with the S&P 500 oh so close to posting new highs — all anyone wanted to talk about was when the inevitable correction would occur.

It�s difficult for the investing public to see this recent rise as anything but a relief rally. Over the past 12-plus years, the market has conditioned us all to think of the downside first. Any upside action is an anomaly — not to be trusted. Fade the rips, as traders often say.

But if you look deep into the belly of this rally at one group of underperforming stocks, you�ll find one of the most bullish indicators is screaming, �Buy this market on the dips.�

Better yet, no one is talking about it�

It comes down to the small-cap sector — an overlooked group of stocks that has woefully underperformed the market since the June 2012 lows.

I�ve been telling the story of small-cap underperformance for the past six-eight months or so. Large-cap stocks — specifically those that pay dividends — were very much in favor as an indecisive market whipped back and forth in 2012. Stocks ended the year on a high note, with double-digit gains intact for the S&P 500. But that doesn�t mean investors felt very good about their prospects.

In reality, 2012 was a year of uncertainty for Main Street and Wall Street alike. Fund managers underperformed. And average investors continued to pull money out of stock funds at a record rate. That means they especially didn�t want anything to do with riskier assets such as small caps. In the minds of investors, the market could have collapsed at any minute. After everything they had been through over the past 12-plus years, there was no extra cash to throw at small, speculative companies.

However, this attitude is quickly changing.

Experienced market watchers know there are two kinds of fear: the fear of losing money and the fear of missing out on a huge rally. Right now we could be seeing the latter showing up in investors� collective psyche. It�s on display as money continues to chase this sharp rally.

But this time, we�re not waiting for the momentum to trickle down to smaller stocks. Since the market started its run, the small-cap names have led the way. After months of lackluster performance, this investing universe just took a huge step forward. As of two weeks ago, the Russell 2000 was up almost 5%. That beats out all the major indexes — including the red-hot Nasdaq. For comparison�s sake, the S&P was up about 4%.

More importantly, the Russell topped its all-time highs. Take a look:

This is a look at the small-cap index over the past 10 years. After the post-2008 crash rally, we saw new highs briefly in 2011. Now we�re seeing the index break out yet again.

The breakout is good for long- and short-term investors alike. I�m always wary of rallies that leave smaller stocks behind. The rationale is simple: Small stocks carry far more risk in the minds of investors than blue chips, household names and dividend names. So without the �speculative sector� participating in a move, are we truly in the midst of a risk-on environment? It can happen — but I would prefer a broad market move that includes (or is led by) small-cap names.

That�s exactly what we�re waiting to see right now. Yes, the market needs to rest here. It won�t go up 4% a week all year. But a powerful start to the year should help coax some of that sidelined money back into equities. If history has anything to say about it, this is only the beginning.