“Small cap stocks are a good investment when innovation is at its peak and during the deflationary shakeout that follows a stock crisis.”

“After the 1974 crash, small caps outperformed large caps by 4 to 1.”

Buying small company (”small cap”) stocks is an investment in the innovative young companies that find and exploit profitable niche markets. Such companies lack a proven track record, but the best of them know their customers well and have a persuasive vision of the road ahead. The small cap companies who thrive and eventually grow to huge size are nimble and adaptable, the so-called “gazelles” that are worth finding and watching closely.

Conventional asset allocation theory tells us always to invest a percentage of our portfolio in small cap stocks regardless of the health of the economy. The truth is that small cap stocks are a good investment during only two of the predictable seasons of the 80-year cycle . As a result, balancing your portfolio between small and large cap stocks while ignoring these seasons is a disastrous way to diversify.

Small companies typically outperform large companies just when we might expect them to, during periods of innovation that occur on a 22-year lag to the birth cycle. This is particularly true when the young people entering the workforce are part of the innovative generation that makes up the first half of the 80-year cycle. For instance, the most recent innovative period occurred from 1958 to 1983, when huge numbers of baby boomers were entering the labor force. This wave of innovation reached a crescendo in the late 70s and early 80s. During this period, Intel introduced the first computer on a chip (1971), Apple introduced the Macintosh (1977) and Microsoft went public (1983). It should come as no surprise that venture capital returns peaked between 1979 and 1983, a strong indication that the computer revolution was off and running.

Intensely innovative periods often coincide with high inflation . As a result, investing in small cap stocks is also a good idea when inflationary pressure rises. For instance, the chart below shows that small cap stocks outperformed large cap stocks 6 to 1 in cumulative returns from 1958 through 1983. The best time to buy small caps was after the 1974 crash. During the subsequent 8 years, small caps outperformed large caps by 4 to 1 in cumulative returns. In fact, small caps had their best years ever in U.S. history when large cap stocks were still heading down and bonds were being decimated by extreme inflation.

“During the decade that the Innovation Wave overlaps with the Spending Wave, both small and large cap stocks to do well. That’s happening right now .”

Investing in small cap stocks is also a good choice in the Deflationary Shakeout or depression era. Since these stocks perform particularly well following a crash, the time to buy is after a stock crisis. For example, from 1932 to 1946 small caps outperformed large company stocks by a margin of about 6 to 1 on cumulative returns. That is an astounding difference.

The seasons of the 80-year cycle that don’t favor small caps are the first phase of the Growth Boom and the first phase of the Maturity Boom. Then you should consider investing in large cap stocks, bonds, and select real estate. It is only in the last decade of the boom that the 22-year cycle for innovation and the 46-year cycle for mainstream spending overlap, with the result that both small cap and large cap stocks do well. The last such period was 1958 to 1968. Both small and large cap stocks are doing well right now, , which began in 1998 and will extend to 2008. Small caps are likely to temporarily outperform large caps from 1999 to 2002 as they catch up from low valuation levels.