Bounce Higher When the Market Rebounds

Despite the recent run-up in stocks, I know that talking about a rebound in the market right now makes me sound like a crackpot. It's comparable to Tom Cruise jumping on Oprah's couch or Gary Busey explaining why he likes eating in the dark -- pure crazy. Right?

If I look at the numbers, though, what seems crazy to me is buying back in 2007, when the S&P's price-to-10-year-average-earnings ratio was above 30. Or worse, buying in 1999 or 2000, when it was darn close to 50. Today, a heck of a lot of optimism has been beaten out of the market, and valuations are already below their long-term averages.

Can prices go down further? Sure! But with the S&P trading for a price-to-10-year-average-earnings multiple of just 15 -- versus a 35-year average of 24 -- the market is padded by less hope and enthusiasm than at almost any time over the past few decades.

You're still with me?
Since you're still reading, I'll have to assume that you think there might be something to this whole market recovery thing. Or maybe you're just waiting to see what other kind of lunacy comes out of my mouth. If you're here for the former, the next question we should address would be how we can position our portfolios for a recovery.

Assuming a rebound is in the cards, buying stocks across the board should yield good results. As investors get more optimistic, valuation multiples will start to expand, and as the economy turns the corner, corporate earnings will reverse their freefall. Higher multiples plus higher earnings equals higher stock prices.

With even long-term outperformers like Hewlett-Packard (NYSE:HPQ) and Merck (NYSE:MRK) trading at single-digit multiples, I figure my dog can pick stocks that will go up when the market starts rising.

We can do better
But I'd like to find the stocks that stand to benefit the most from a market turn. Those stocks can be summed up in two words: small caps.

Looking back to 2002, we can see exactly what this means. In the year following the October market bottom, stocks with a market cap greater than $250 million jumped an average of 51%. In the two years following the bottom, that same group gained 72%.

However, if we cut the group down to just the stocks valued between $250 million and $1 billion -- just the small-cap whippersnappers -- the gains improve to 62% and 85%, respectively. Many of today's well-known large caps, such as Research In Motion (NASDAQ:RIMM) and Arcelor Mittal (NYSE:MT), were among the small caps in 2002 that helped generate this incredible performance.

Not only did small caps outperform after the last bear market, but historically, they have also outperformed heading out of recessions.

A Wall Street Journal article pointed out that many investors are looking to small caps to lead the market again, and it suggested that the Russell 2000 index's outperformance during the late 2008 rally may be a harbinger of what will happen when we do get a sustained recovery.

Scouting small caps
Ronco does rotisserie cookers, not stocks, so there's no "set it and forget it" when it comes to individual stocks -- particularly when we're talking about inherently volatile small caps. For investors who don't have time to get their hands dirty with research and keep tabs on the stocks they own, investing in individual small caps is not a good idea.

These investors can still benefit from small caps, though -- they can grab a Russell 2000 index fund or ETF, or invest with a quality mutual fund that focuses on small caps. The Journal article I mentioned above suggests Natixis Vaughan Nelson Small Cap Value (NEFJX) and T. Rowe Price Small-Cap Value (PRSVX), among others.

The best returns, though, will go to the investors who are willing to spend the time finding high-quality, but small and relatively unknown companies with the potential to become multibaggers when Mr. Market turns his frown upside down. These companies may take a little extra work to find because they're not well known, but they are lurking out there. In fact, here's a look at a few that could be worth more research:

Source: Capital IQ, a division of Standard & Poor's.

But what if you want to benefit from individual small caps and are willing to put in the work, but would also like some researched stock ideas and some other investors to trade ideas with? For you, The Motley Fool's Hidden Gems newsletter may be the way to go. This small-cap-crazy newsletter team does exactly what I've outlined above -- that is, dig through the vast universe of small-cap stocks looking for the best-run, highest-quality companies that Wall Street doesn't have the time for. In the most recent issue, the team highlighted an aerospace specialist and an infrastructure player that they think are poised to sprint ahead of the market. You can get the down-low on both of these stocks by taking a free 30-day free trial of Motley Fool Hidden Gems.

But whether you check out what the team has to offer or not, now might be a good time to stop looking at me like I'm crazy and take a look at your portfolio, to make sure you haven't left small-cap stocks out in the cold.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. GigaMedia is both a Motley Fool Global Gains and a Motley Fool Rule Breakers selection. The Fool’s disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants …