In the darkest hours of the market, we need to be looking for the next bull. Louis Basenese says the lessons from history show that traditionally riskier small-cap stocks could actually be the smartest bet right now.

Yesterday we got confirmation that the U.S. economy contracted by 0.5% in the third quarter. And most economists expect the downturn to accelerate, with GDP checking in as low as negative 6% in the fourth quarter. Here’s why I’m not concerned…

A more important trend is emerging. Remember, on November 19 I told you to consider going big, by going small with small caps. Well, the markets didn’t leave much time for preparation.

In that short span, small caps jumped 6.38%, almost tripling the returns of large caps, based on the Russell 2000 and Russell 3000 indexes. Of course, it’s too early to declare a full-blown rally. But we shouldn’t be ignorant to the subtle shifts in market leadership.

Remember, the market’s a forward-looking beast. And that means even in the darkest hours we need to be thinking about the next bull market… and positioning ourselves to profit.

The more I research and monitor the markets, the more convinced I become that the time for small cap stocks is upon us. In the next two columns, I’ll do my best to convince you of the same.

Today, I’ll focus on the why. Next week, I’ll show you how to screen for the most potent opportunities, as well as provide a few specific recommendations.

Before we get to it…

Making Sure You’re Ready To Buy Small Cap Stocks

Before I lay out the case for small cap stocks, we need to make sure you’re ready to buy. After a brutal 2008, I fear many of you may have packed it in for the year. But sitting cash heavy right now is a big mistake…

First of all, two of the fastest-rising bull markets occurred in the 1930s. So don’t kid yourself. Times are tough. The economy’s in the tank. But this market, just like during the Great Depression, could turn on a dime, too.

That means if you’re not positioned ahead of time, you’re certain to miss out.

As Minneapolis investment research firm The Leuthold Group reveals, in the first year of every new bull market since 1900, the Dow jumped an average of 41%. Keep in mind, the average total bull market gain over the same period was 84%. In other words, bull markets are heavily front-loaded.

And Standard and Poor’s agrees. They estimate most investors make back 82% of their bear market losses in the first year of a bull market.

Bottom line – being late to the next bull market comes with a big price tag. And I don’t want you to pay it.

Why 2009 Will Be a Small-Cap Stock World After All

Now that you’re primed, let me tell you why jumping into the deep-end and buying traditionally riskier small cap stocks is actually the smartest bet right now. I’ll let the data, not my own personal convictions, do most of the talking…

• Coming out of recessions, nothing beats small caps. Last month, the National Bureau of Economic Research (NBER) made it official. The U.S. economy is in a recession. No matter when we make the calculation (after one month, six months, one year, even three years) small cap stocks trounce their larger brethren coming out of slowdowns, according to the data crunchers at Old Mutual and Morningstar.

• Even if the economy doesn’t recover in 2009, small cap stocks should shine. The latest from Citigroup Global Markets indicates small caps could care less about the underlying economy. Even in years of flat or negative GDP growth (up to 2%), small caps return an average of 44%.
• One month can make a difference. Based on the 10 worst years for stocks since 1927, small caps jumped 18.17% in January alone. Meanwhile, large caps barely showed up for the much-heralded January effect. They only muster a 3.1% gain, on average, according to Cambria investments. I don’t know about you, but the prospect of one-month double-digit gains, especially after this year’s drubbing, excites me. The fact that they could come just weeks from now is even more tempting.

In the end, only time will tell if a small-cap rally is truly underway. By then it will be too late. I suggest you heed the data that keeps piling up in favor of small caps. I’m not saying you should invest in nothing but such stocks. But you should at least consider increasing your exposure.

Here’s one last data point to chew on: Since 1926, Morgan Stanley found large caps return more, on average, when they trail small caps. When large caps lead the way they only return 7% per year on average. When small caps shine, large caps return 13% per year, on average.

Put more plainly, a small-cap rally is a win-win. Their strength brings our large-cap holdings along for the ride, too.

Source: Small-Cap Stocks: The Most Important Trend Headed Into 2009