We all know we should “buy low” and “sell high”. In this post, we explore a group of stocks who are “buy low” candidates. These “buy low” candidates may be ready to shine if two longer-term trends assert themselves—this is known as reversion to the mean, a financial term for the assumption a short-term trend will eventually reverse itself to match a longer-term trend.

Historically, stocks of smaller companies have performed better than stocks of larger companies. Value stocks have also historically performed better than growth stocks. Value stocks tend to trade at cheaper prices relative to their earnings than growth stocks. Growth stocks represent companies expected to have strong earnings growth and sell for more expensive prices relative to their current earnings than value stocks.

In recent years, the opposite has been true. Large company stocks have outperformed small company stocks while growth stocks have outperformed value stocks. These short-term trends have reached such an extreme, creating a potential opportunity to profit should the longer-term trends assert themselves. Specifically, we evaluate one investment set to capture profits if both of these short-term trends reverse themselves in favor of the historical relationships.

1. Long-Term: Small Caps beat Large Caps

The chart to the left shows the performance of US Large Cap stocks (SPX) versus the performance of US Small Cap stocks (RUT).

Over the last 30 years, the overall returns have been similar. SPX and RUT have taken their turns in outperforming each other.

After the bear markets in 2002 and 2008, RUT outperformed SPX.

2. Short-Term: Large Caps beating Small Caps

The chart to the left shows the performance of US Large Cap stocks (SPX) versus the performance of US Small Cap stocks (RUT).

Over the last five years, SPX has outperformed RUT. Recently the outperformance (the gap between the two) has reached an extreme by historical standards.

3. Long-Term: Value beats Growth

The chart to the left shows the performance of US Growth stocks (RUO) versus the performance of US Value stocks (RUJ).

Over the last 20 years, the overall returns have been similar. RUJ has outperformed RUO for most of the time until recently.

4. Short-Term: Growth beating Value

The chart to the left shows the performance of US Growth stocks (RUO) versus the performance of US Value stocks (RUJ) since 2009.

Over the last 10+ years, RUO has outperformed RUJ. Recently the outperformance (the gap between the two) has reached an extreme by historical standards.

5. Mean Reversion Opportunity

Historically we know Small Caps have performed similarly to Large Caps. Historically, we know Value has outperformed Growth. In the short-term, the opposite of history has been happening. We have two trends have reached historically extreme levels:

Large Caps > Small Caps

Growth > Value

If the historical relationship between these investments will continue to hold in the future, we would expect Small Caps to outperform Large Caps and Value to outperform Growth. We can express this view by investing in the Small Cap Value ETF (ticker: IWN).

6. Buy Low After Market Confirmation

The chart to the left shows the weekly prices of the Small Cap Value ETF (IWN).

At the low in March 2020, IWN had fallen 50% from its high in August 2019.
We prefer to wait for the market to confirm our thesis before buying. In this case, we needed IWN to rally above the purple line before buying. IWN has room to rally 42% before reaching the all-time high.