Why Small Caps Should Outperform In January

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One of the best-known seasonal trades is the "January Effect", where small stocks outperform larger ones at the beginning of the year as they recover from tax-loss selling and window-dressing by investment professionals. The first published study of the anomaly was by Donald Keim, in 1983. Almost 30 years later, it is, not surprisingly, so well known that it no longer typically works.

Before I say why I think we are headed for a text-book case in 2012, let me first explain why it failed so miserably in 2011. In late December, while I am normally enthusiastic about Small-Caps, I published a cautionary outlook, as I felt like the tailwinds were dissipating. 2011 ended up being tough for Small-Caps vs. Large-Caps (they are currently lagging by about 5%), but it was the ugly January that really proved to be a harbinger. What happened?

The Small-Cap Russell 2000 beat the Russell 1000 handily in 2010, edging the Large-Cap index, which returned over 16%, by more than 10.5%. Q4 was phenomenal, with Small-Caps outpacing Large-Caps by over 5%. Even December saw dominance from the smaller companies. The reason that there was no January Effect is that there was very little tax-loss selling in aggregate. So, it shouldn't have been too surprising to see the R1000 rise in January by 2.4% while the R2000 posted a small decline. Rather than sell for tax-losses in December of 2010, Small-Cap investors actually deferred gains until January 2011. The rocket reignited for the next three months.

Before I look ahead, let's go back one more year. 2010 got off to a terrible start, with Small-Caps falling just a little less than Large-Caps. Again, this was the tax-deferral selling, but for the whole market, which had soared in 2009. I had actually shared my view in early December 2009 that December might be the new January. This perspective isn't dated and is worth a read, as the January Effect really does seem to have accelerated in recent years, perhaps as hedge-funds and other managers have recognized the logic behind the long-term record of success.

Given my concerns that the anomaly is no longer reliable, it's especially important to think through why it might be a winner next month. I think the stars are aligned, as Small-Cap has been a dog this year. The overall R2000 is down 3.3%, while the R1000 is up 2.1%. Almost half the R2000 is down more than 25% from its 52-week highs, and 18% is down more than 50% from the 52-week high. While the index is down 3.3%, almost 1/3 of the stocks are down more than 20% YTD. Thus, it's likely that we have seen a lot of tax-loss selling this quarter, setting us up for reversal in January. Unfortunately for my Top 20 Model Portfolio, I can sadly point to several examples of apparent end-of-year selling!

There has been a small recovery in the relative relationship so far this quarter, but it all happened in the big October move, when the R2000 rose 15.1% compared to 11.2% for the R1000. I viewed that move as being consistent with the relative betas. In November, there was a very slight deterioration (0.1%), while in December there has been a very slight recovery (0.2%). Comparing to the biggest stocks (the Top 200 of the Russell, for instance), the strong month of the really big stocks (that index is up over 3% in December) really sets up the trade (and encourages me about the overall market). My point is that the January Effect hasn't moved into December or even November this year.

Small-Caps look to me like they are poised to enjoy an old-fashioned January Effect, with a rally that sharply exceeds what I expect will be a good month for Large-Caps too. If so, it will be the first time in six years that the January Effect has worked as the original research suggested. In January 2006, the R2000 soared almost 9%, beating the R1000 by over 6%. What a nice way that would be to start 2012!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.