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Bank Stocks, Small-Caps May Be Headed for a Happy New Year

Bankers have never had it so good:

- The S&P/Experian Consumer Credit Default Index is near a record low of 1.38 percent.

- A steep yield curve (2-10 spread at 242 basis points) provides ample opportunity to write profitable loans.

- The Fed continues to supply unprecedented liquidity, even paying 25 basis points on excess reserves.

No wonder the Bloomberg Financial Conditions Index is at a 20-year high.

Our knee-jerk reaction comes as no surprise:

Bank stock performance has been incredibly steady. It was even in May, when Fed Chairman Bernanke lobbed his first "taper talk" curve ball. The trend is intact, as are the aforementioned conditions, so it's still comfortable to be on the long side.

Now, digging a little deeper, there's a second opportunity: small caps. Strategist Chris Verrone (www.strategasrp.com) determined that small caps tend to outperform large caps during quarters when the Bloomberg U.S. Financial Conditions Index is positive. In other words, small caps do well when economic conditions that are conducive to lending coincide with favorable business environments. Smaller, growth oriented companies are the obvious beneficiaries, and they have outperformed on a quarterly basis by 110 basis points since 1994.

What's particularly curious this quarter is that small caps are lagging. Historical analysis suggests they should be outperforming. So our second idea: take a look at iShares Russell 2000 Exchange-Traded Fund (IWM ). As markets ride the momentum into year end, small caps may accelerate.

For emboldened blog readers looking to combine both ideas (long banks, long small caps), there's the regional banks SPDR Regional Banking Exchange-Traded Fund (KRE ). Median market capitalization is $2.4B (compared to $62B for the Financial Select Sector SPDR Fund --XLF ). In addition, it trades at a moderate 12.2x price-to-earnings ratio and it's up almost 44 percent this year.

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