By Jim Fink on January 30, 2013

In Buy Small-Cap Stocks Before They Grow Up . I discussed how small-cap stocks ($250 million to $3 billion) have outperformed large-cap stocks (over $10 billion) by a significant amount over the long term. Since 1926, an investment of $10,000 in large-cap growth stocks became about $10 million but the same amount in small-cap value stocks exploded into almost $900 million !

Small and mid-cap stocks comprise about 20 percent to 25 percent of total stock market capitalization (page 4), so a market-neutral exposure requires that a similar percentage of your personal equity portfolio should be allocated to small and mid-caps. Simply put, if you want outsized returns, you must invest in small-cap stocks. All ten of the top-performing stocks of the past decade were small caps and most were value stocks. I can almost guarantee that the top-performing stocks of the next decade will be small caps as well.

But long-term outperformance says nothing about the short term, and small caps dont outperform large caps all of the time. As both Vanguard founder Jack Bogle and The Leuthold Group have pointed out, small-cap and large-cap stocks alternate multi-year time periods where one group does better than the other. The question investors face today is whether small caps or large caps are likely to outperform in the immediate future?

Looking at the political and economic landscape right now, I am convinced that the pendulum of future outperformance appears to be squarely in favor of small caps . My reasoning centers around two powerful forces:

1. The U.S. recently re-elected a Democratic President to a new four-year term; and
2. The Federal Reserves money-printing program currently $85 billion per month in quantitative easing is likely to stoke inflation and stronger economic growth.

Both of these forces are extremely favorable for small-cap stocks. According to a 2008 academic study. Relative to large cap equities, small caps are more sensitive to changes in political and monetary conditions (page 8).

DEMOCRAT PRESIDENT

A second Obama administration bodes well for small stocks. However you feel about the 2012 election, theres a well-documented reality that cant be ignored: stocks generally perform better during Democratic presidencies. Even better, a 2003 study and a 2012 study both conclude that small-cap stocks significantly outperform large-cap stocks during such periods of Democratic control.

The research backing this finding goes all the way back to 1929. Indeed, from 1927 to 1998, small-cap stocks perform an astonishing 18% per year better during Democrat administrations and beat large caps by 7.5% per year, compared to underperforming large caps by 4.5% per year under Republicans. Whats more, the updated numbers through 2010 (which include the Clinton and Bush years as well as the first two years of Obama) uphold the small-cap outperformance in Democratic administrations:

1927-2010 Annualized Return: Small Caps vs. Large Caps