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The Santa Claus rally has been associated with a stock market rally in December. Mark Hulbert explains:

There is one version of the Santa Claus rally that enjoys strong historical support: the last five trading sessions of December and first two of January.

This year, for example, a trader wishing to capture this rally would buy stocks as of the close on Dec. 23 and sell them at the end of the trading session of Jan. 3. Traders have been aware of this particular version of the Santa Claus rally at least since 1972, which is when the editors of the annual Stock Trader’s Almanac say they discovered it.

The superior performance appears to be most pronounced in small cap stocks:

Norman Fosback, editor of Fosback’s Fund Forecaster and former president of the Institute for Econometric Research, says that seasonal patterns in large-cap stocks have “receded in significance” in recent years.

Unfortunately, the smallest-cap stocks for which seasonal patterns remain the strongest also tend to have the highest bid-ask spreads.

These “microcap” stocks — a loosely defined category that contains issues that are even smaller than the small caps—tend to range in size between $100 million or so and $1 billion in total market value.

Fosback nevertheless favors the microcap category for the seasonal portfolio he recommends to clients, though not by buying and selling individual stocks. Instead, he prefers the iShares Micro-Cap ETF, with an expense ratio of 0.72%. The fund replicates the performance of the smallest 1,000 stocks in the Russell 2000 Index RUT +0.14% ; the average market cap of the stocks it owns is $420 million.

Small cap seasonality charted

Indeed, the seasonal pattern of the relative performance of small cap stocks, as represented by the Russell 2000, show that they tend to outperform late in the year:

Russell 2000 seasonality
(click to enlarge)

The seasonal pattern of the iShares Micro-Cap ETF (NYSEARCA:IWC) is even more pronounced than the Russell 2000:

IWC seasonality
(click to enlarge)



A European small cap opportunity

However, there may be a way of extending the positive effects of small cap seasonality well into the New Year. I discovered that European small caps have a tendency to outperform in both January and February. The chart below shows the relative return pattern of DFE, which is an ETF representing European small cap stocks, against FEZ, which is an ETF representing eurozone large caps.

DFE vs. FEZ seasonality
(click to enlarge)

The relative returns of DFE against FEZ show that European small caps remain in a multi-year relative uptrend compared to large caps and the trend is supportive of further small cap outperformance.

(click to enlarge)


Underpriced growth

In addition, there appears to be strong fundamental support for European equities. Thomson-Reuters analyzed the consensus implied forward EPS growth rates compared to the Starmine (smart analyst) estimates and found that the Starmine estimate for Developed Europe is 6.0% compared to the market implied estimate of 0.6% - a considerable spread.

(click to enlarge)
(click to enlarge)

By way of comparison, the equivalent figures for North America is a Starmine growth rate of 8.0% compared to a market implied growth rate of 6.1%. While the spread is positive, this analysis suggests that the opportunity is better in Europe.

Under these circumstances, I would be more inclined to focus on European small caps as they tend to be more exposed to the local economies than the large caps, which have a relatively large weighting in global companies such as BMW, SAP, EADS (Airbus), pharmaceuticals, luxury goods makers, etc.

Will the ECB provide a tailwind for small caps?

As well, the ECB may be coming to the aid of European companies. Last week, David Keohane at FT Alphaville highlighted an ECB "trial balloon" which would provide greater liquidity for SMEs. If such a step were to be taken, it would provide a greater boost to the European small cap space [emphasis added]:

The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources.

ECB President Mario Draghi and other Governing Council members have repeatedly mentioned the option of conducting more liquidity operations, or LTROs, to help the fragile euro zone economy and ensure the flow of credit to the private sector.

The ECB extended more than one trillion euros ($1.36 trillion) of cheap three-year loans to banks through two long-term refinancing operations in late 2011 and early 2012.

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The new LTRO could also run for only nine or 12 months, the paper said.

In conclusion, traders who want to play the small cap Santa Claus rally may wish to rotate from U.S. small caps into European small caps in the New Year. The combination of positive seasonality, undervalued growth potential and possible ECB support for SMEs suggests that European small cap stocks are likely to see a tailwind heading into 2014.

Disclosure: Long DFE

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Source: How To Stretch The Santa Claus Rally Into 2014