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January has historically been the best month to invest in small company stocks relative to large company stocks. Most of the long-term out performance by small-caps can be attributed to the month of January, and so far at least, 2013 has been no exception. The Russell 2000 (IWM) has outperformed the S&P 500 (SPY) by roughly 0.7% through the first week of the year. Based on the historical data (see below) many investors are likely to continue to hold an overweight position in small caps for the next few weeks in hopes of capturing that additional 1.6% of outperformance, but I would recommend digging a bit deeper first.

Has 'The January Effect' worked recently?

Due to the significant coverage of the January effect, many investors and asset managers are now aware of the historical benefit of an overweight position in small cap stocks in January, and as a result, many have changed their investment behavior to seize upon the perceived opportunity. This shift in investor behavior has likely changed the effect. In three out of the previous four years, small cap stocks have outperformed in December (as investors now wanted to front run the effect) and then actually lagged in January.

(click to enlarge)

If you notice on the chart above, which reflects the recent relative performance of the Russell 2000 versus the S&P 500, the 'January effect' may be better termed the December effect. Not only has outperformance occurred more often in December, but relative outperformance in December has generally led to underperformance in January. In December 2012, the Russell 2000 outperformed the S&P 500 significantly. Also of note, when the Relative Strength Index [RSI] exceeded 70 on this ratio, it provided a great signal to rotate back into large caps. The current RSI stands at 75.96.

Aside from seasonality, how do Small Caps compare to Large Caps from a value perspective?

P/E RATIOS

1/4/2013†

Year ago†

Russell 2000

31.10

46.36

S&P 500

17.28

14.78

† Trailing 12 months P/E data based on as-reported earnings

Source: Birinyi Associates

Realizing that both of the indices are expensive relative to their individual historical norms and also that the valuation spread has narrowed considerably as compared to one year ago, the S&P 500 is still significantly cheaper than the Russell 2000 on a price to earnings basis. Granted, cheaper is not always better. An index with a higher multiple may still be more attractive if you expect a higher rate of earnings growth. The key questions become: "Do you expect better earnings growth in small capitalization stocks?" and "Does that difference in growth warrant the difference in earnings multiple?"

The Conference Board is currently projecting that in 2013, the US economy will grow at an underwhelming 1.8% versus 3.3% for the remainder of the world. If the Conference board is correct, an investor could naturally expect international real earnings growth to exceed domestic real earnings growth by 1.5% for the year. Currently the companies that make up the S&P 500 receive roughly 46% of earnings internationally versus only 19% on the Russell 2000.

Assuming that we have a pretty even distribution of earnings growth across stocks of different market capitalizations, the difference in the geographical composition should provide more than a half of a percent real earnings growth advantage for the S&P 500. Granted, the distribution of earnings is not likely to be even, but any difference in the earnings distribution should not be so severe as to offset the geographical earnings advantage, at least not to the point where the Russell 2000 would warrant such a dramatically higher earnings multiple.

Do the charts provide us any additional insight?

A quick look at small caps on a weekly chart of IWM with Bollinger bands set at 2 standard deviations from the 10 period moving average is quite revealing.

(click to enlarge)

The chart seems to indicate that the Russell 2000 is overbought and due for at least a short-term correction.

Does the S&P 500 really look any better here?

Although a better relative value than the Russell 2000, the S&P 500 is similarly overvalued and the charts look similarly overbought. The S&P 500 also closed above its weekly Bollinger band and the shorter-term chart is also showing significant negative divergence.

(click to enlarge)

Conclusion:

US equity markets as a whole look overbought and due for at least a short-term pullback. As the January (possibly now December) effect wears off, it seems as if small cap stocks will likely underperform through the expected pullback and quite possibly for some period beyond. With the upcoming congressional drama surrounding both the sequestration deadline and debt ceiling breach and given the recent collapse in the VIX making protection cheap, I definitely see some hedging and possibly some opportunistic short positions in my future.

Source: Is It Time To Bail On Small-Cap Stocks?