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Small-Cap Trader Blues? The Calendar May Bring Some Cheer

December 30, 2014
Small-Cap Trader Blues? The Calendar May Bring Some Cheer

Small-cap traders may be feeling a bit bruised as the year draws to a close, their blue-chip brethren having hogged most of the headlines (and gains) as the U.S. bull run plowed along.

But take heart small-cap folks – the calendar may be coming to your rescue.

We’re talking about the January Effect, an ancient market phenomenon wherein shares of smaller companies tend to outperform large-cap stocks. Indeed, small-caps have outperformed large caps in 40 of the past 43 years during the typical January effect timetable, according to the Stock Trader’s Almanac.

The January Effect, so the theory goes, reflects large institutional investors and traders stepping up bets on more speculative, growth shares soon after the year-end holidays. If the institutions play their cards right, they can ring up outsized gains, and beat the traditional index benchmarks, during the first part of a new year, then coast the rest of the way, hoping to hang onto a coveted “outperformer” tag.

In 2014, the large-cap benchmarks obviously stole the show, with the Standard & Poor’s 500 Index notching 49 record closes—roughly equivalent to a new record every week—gaining nearly 12% for the year through December 19. Meanwhile, the Russell 2000 small-cap index was up just over 2%.

At least some of the fuel driving large-caps higher in recent years was tied to corporations buying back their own shares. But buybacks appear poised to slow down, and that could help small-caps catch up.

A trader can take advantage of a January Effect simply through speed, agility and paying attention – jumping into the small-cap pool before institutions build their positions. The astute traders eyes the markets closely around this time of year for a related seasonal pattern, the Santa Claus rally.

However, there are a couple of caveats at the moment. Since around March, small-cap stocks have displayed low relative strength, a technical indicator, compared to the S&P 500 (see Figure 1). Also, during the market’s rebound from the broad-based October sell-off, the Russell 2000 lagged the S&P 500.


Over the past two years, the small-cap Russell 2000 Index (top, dark line) lagged the S&P 500 (blue), which is reflected in declining “relative strength” (bottom line). Relative strength measures performance of a security or index against another.  Source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only.

This suggests institutions aren’t as interested in small-cap stocks—at least not yet. Any unwillingness among institutions to speculate on small-caps might reflect general bearishness; they may instead choose to hang on to blue-chips into the new year.

However, if the real reason institutions aren’t buying is due to economic concerns over smaller companies, then relative strength is measuring the winner of the race to the bottom.  

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