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A few months ago, my father-in-law, Julio, who doesn’t know much about investments, was bragging that he didn’t lose any money during the market crash in 2008. He said he couldn’t understand why so many people had their accounts decimated.

I was very curious, so I asked him if I could take a look at his 401K statement. I was not surprised to see that he had almost 90% of his investments in a money market account. No wonder he didn’t lose a whole lot during the market crash.

One of my neighbors, John, on the other hand, lost almost 50% of his retirement account when the market crashed. He still hasn’t recovered all the losses he suffered.

Both Julio and John were planning to retire a couple of years ago. Both had to delay their plans, but for different reasons.

My father-in-law wasn’t able to grow his account in any significant way because he was just playing it way too safe. In fact, almost all of his account growth came from contributions, not from investment returns. John, who was trying to grow his account by having a heavy allocation in stocks, got burned by the crash.

And that reflects the big dilemma investors close to retirement are facing today.

If you have a defensive portfolio, you get no growth. If you shoot for growth, you risk not knowing when the market may turn again.

I’m concerned about my father-in-law… as well as John. They both look to me for investment advice. Over the past few months, I’ve been testing many different strategies to find a safe way to generate income and keep your retirement account growing at the same time. And that’s why today, when they look to me for answers, I tell them to look at small-cap stocks.

Seeing the Writing on the Wall

The market is like a big puzzle where all the pieces are interconnected. Stocks, commodities and bonds send important messages every time they move. If you can read those messages, you can tell how other investors feel about market sentiment, the risk of inflation, economic growth, etc… and what they are likely to do with their money in the next few months.

I’ve been studying these messages, and, so far, I’ve been able to figure out a pattern that tells me where money is going to flow into and which areas will see an outflow of investor money. This is important because usually when money starts flowing into a particular asset, that asset outperforms the market.

Right now, the market messages tell me you have to have some exposure to small caps.

Since May of 2011, small-cap stocks have performed worse than the S&P 500 index, as you can see in the chart below. Investors have been giving preference to blue chips, which are viewed as defensive plays. They’re less volatile, but also offer lower growth potential. This trend of underperformance may be changing, however.

Small-Cap Stocks Have Underperformed for the Past Year

See larger image

Small caps have been catching up recently. Since August, the Russell 2000 Index, which measures the performance of small caps, is up 9.34%, while the S&P 500 index is up a little more than 4%.

The last time small caps started this kind of outperformance was in October of 2010 and 2011. In both occasions, the S&P 500 index rose about 17% in the following six months. The Russell 2000 Index rose 26% on average, outperforming the market.

It’s Time to Go Small

“Downturn in China spreads to key sectors,” “Euro zone enters dangerous week,” and “U.S. jobs report figures disappoint” are some of the headlines I came across this weekend. And this flood of bad news has been going on for the past couple of months. With so many gloomy stories in the mainstream media, no wonder many investors are hoarding their cash.

But the truth is the market is forward looking. And for a while now the market has been telling us things will get better, not worse.

While it’s easy to get caught up in the gloomy headlines and fears of a coming crash, the recent rally in small caps suggests the market will continue to move higher. With the kind of performance small caps have had lately, the writing on the wall is that we could see some big upward moves in the market in the next six months.

To make sure you meet your retirement growth goals, now is the time to increase your allocation to small-cap stocks.


Evaldo Albuquerque

P.S. Not all small caps are created equal, as my colleague, Jeff Opdyke, can tell you. For his Global Growth Strategist subscribers, Jeff is looking at small U.S. companies that are finding big profits overseas. Right now, he’s looking at one company in particular that he says owning today could be like owning Wal-Mart in the ’80s, or Microsoft in the ’90s. To learn more about his research, click here for Jeff’s latest video report.

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