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Alan Brochstein, 420 Investor (1,292 clicks)
Contrarian, growth at reasonable price, management change, cannabis stocks
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The "January Effect" is one of the very few well-studied seasonal trends that has persevered the test of time, though it has clearly lost a bit of its punch in recent years. According to Wikipedia, it was first noted by Donald Keim, who published a paper in 1983 as a grad student at the University of Chicago, but there were other studies prior to this one that noticed peculiar excess returns for stocks in January in markets around the globe.

The basic theory is that smaller stocks fare poorly at the end of the year but rally sharply in January. Most of the original research attributed this anomaly or inefficiency to tax-loss harvesting. Three weeks ago I noted that Small-Caps were getting hammered relative to larger companies. I mentioned the traditional tax-loss selling but also the sharp decline of the dollar (larger companies tend to be net exporters) and what I think is actually the most powerful dynamic: hedge-fund repositioning. Those comments were a bit early, but, since the beginning of December, smaller stocks have surged as you can see in the chart that I have updated below: [click to enlarge images]

Rus2 vs SPX
The S&P 500, the NASDAQ, the NYSE and the Dow Jones Industrial Average all put in new highs Friday, but the Russell 2000 needs to rally about 4% to take out what had looked like a double-top. It will be interesting to see how it plays out, but I think that a strengthening dollar trade will help smaller companies recover some of their recent and still large relative losses since the beginning of this quarter.

I want to share my perspective that the old "January" trade may actually be moving up a bit in the calendar. I believe that the increasing importance at the margin of hedge funds is the underlying reason, as they typically exploit their research most effectively in smaller companies.

Given the large trend in recent years towards performance-fees, it isn't surprising that we might see some net selling by that group as we near the end of the year. This is just a theory, but other investors may be stepping into relative weakness that exists as the year comes to an end. The cynic in me also thinks that a lot of the cash that has been raised in this process is redeployed to result in a good mark at year-end too. In any event, the table below, which looks at the returns over the past decade for the Russell 2000 and compares them to those of the Russell 1000, seems to demonstrate this acceleration of what used to be a January trade:

January Effect
Even excluding the off-the-charts Januaries from the past two years, the trend is clear: Small-Caps do better in December than January typically while picking up more relative performance earlier too. Our sample size is too small to be statistically significant, and the effect isn't 100% of the time, but 7 of the past 10 years have seen better relative Decembers than Januarys.

We are already off to the races this year, and perhaps I will have to start talking about a November effect instead of a December effect next year (once everyone figures it out!). I am not sure how it plays out. It does seem reasonable to expect the Russell 2000 to test resistance at 640 (up 6% from here), and that could certainly happen this month. On the other hand, maybe the double-top, which still stands in divergence to the rest of the market, will prove to be real. In that scenario, I wouldn't be surprised to see dollar strength, suggesting perhaps that smaller companies hang in better as the market fades.

In any event, I have positioned the portfolio I manage to take advantage of the improving relative outlook for Small-Caps. The largest holding is under $4 billion, and the median market capitalization is under $600mm. My Top 20 Model Portfolio, which is up 59.5% this year, has a median market capitalization of under $800mm with just a single stock greater than $10 billion.

Author's Disclosure: No stocks mentioned

Source: Is December the New January for Small Caps?