Why blue chips are likely to outperform small caps in this market sell-off

Things are looking ugly my fellow Fools and it’s likely to get worse before it gets better. The big sell-off in overseas market is threatening to sink our market this morning and the selling pressure is unlikely to abate anytime soon.

We’ve entered into the dreaded “sell in May” season that typically heralds a period of underperformance for share prices as we head into the new financial year.

If you are worried if the sell-off will lead to something more sinister, there’s some good news on this front although I think small caps will bear the brunt of any market meltdown.

Markets are being rattled because investors have lost their appetite for risk. Uncertainty over whether fresh Italian elections could lead to a break up of the European Union (EU) is the latest excuse investors are using to sell-first and ask-later.

US President Donald Trump is another wildcard as his on-again off-again “bromance” with China’s president Xi Jinping has moved to the “off” position. The US is threatening to impose tariffs on US$50 billion of Chinese imports.

We can also point our finger at the slumping oil price for triggering the recent sell-down on our market as the supply of crude is forecast to increase in the near-term.

However, the geopolitical risks are nothing new and the falling oil price is actually great news for economic growth (unless you are an oil company) as lower fuel costs are stimulatory to consumer spending.

The fact is, the solid fundamentals for company profit growth have not changed as analysts have not downgraded their forecasts for the market.

This leads me to believe that the sell-off is driven more by the risk-off sentiment than fundamentals. Global markets have performed very well over the past year and investors will look for reasons to take some chips off the table.

However, I suspect small caps will be the worse-for-wear. These pocket rockets have left the big boys in the dust with the S&P/ASX SMALL ORDINARIES (Index:^AXSO) (ASX:XSO) index surging more than 20% over the past year compared to a 5% gain by the S&P/ASX 200 (Index:^AXJO) (ASX:XJO).

You only need to look at the 400% plus gains by emerging medicinal cannabis stock Cann Group Ltd (ASX: CAN), baby food maker Bubs Australia Ltd (ASX: BUB) and online retailer Ltd (ASX: KGN) to see what I mean.

In contrast, even if you added the gains of the three best performing large caps, gas producer Santos Ltd (ASX: STO), gaming machine maker Aristocrat Leisure Limited (ASX: ALL) and sleep disorder treatment device company RESMED/IDR UNRESTR (ASX: RMD), they still couldn’t beat the gains of any one of the top three performing juniors.

There’s much more room to fall at the smaller end of the market, but that isn’t the only reason why I think blue-chips make a better bet if you are buying the dip.

In a risk-off environment like we are in now, junior stocks suffer the most as they are seen to be riskier propositions.

What’s more, when market sentiment turns later this year I can’t see small caps outrunning big caps by quite the same margin.

This means investors should be better off focusing on opportunities at the bigger end of town as the market falls.

But there’s no need to rush to buy. I suspect the market will be weak for the next month or three.

If you are looking for blue-chips to buy in the market correction, follow the free link below to find out Motley Fool’s top three favourite blue-chip stocks for 2018.

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Motley Fool contributor Brendon Lau owns shares of Aristocrat Leisure Ltd. The Motley Fool Australia has recommended ltd and ResMed Inc. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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