ShareThisOriginally published in the December 20th 2008 edition of the Financial Post section of the National Post.
Small cap U.S. indices such as the Russell 2000 Index have a history of outperforming big cap indices such as the Russell 1000 Index or the S&P 500 Index from the middle of December to at least the end of January. Will the “Small Cap Effect” happen this year?
Seasonal influences
Several analysts recently have commented about the Small Cap Effect. Thackray’s 2009 Investor’s Guide notes that the Russell 2000 Index outperforms the Russell 1000 Index from December 19th to March 7th. The Russell 2000 Index rose in 23 of the past 29 periods for an average gain per period of 6.6% and outperformed the Russell 1000 Index by an average of 3.7% per period. A comparable study by Ned Davis Research for the past 10 periods from December 15th to January 31st indicated an average gain per period by the Russell 2000 Index of 5.42% versus an average gain per period by the S&P 500 Index of 1.30%.
The Small Cap Effect is influenced by a series of recurring annual events near year end. Studies show that tax loss selling by individual investors and year end portfolio window dressing by institutional investors tend to have their greatest impact on small cap stocks that have experienced a large year-end drawdown. These stocks have a tendency to outperform during the Santa Claus rally period at the end of December and into the New Year.
Another favourable recurring influence is a tendency by institutional investors to focus on small cap stocks early in the New Year. Well known big cap stocks officially displayed on year end statements are partially replaced with small cap stocks considered to have greater growth potential or value.
Chart courtesy of StockCharts.com www.stockcharts.com
The enclosed chart shows optimal technical entry points for the Small Cap Effect during the past eight years. Please note that the trade did not work last year when subprime concerns generally precluded interest in the U.S. equity market.
What about this year? Prospects for the Small Cap effect are above average. Many U.S. big cap stocks have become small cap stocks in 2008 due to the stock market meltdown since mid September. At least some of these stocks have exceptional value at current prices. The stage is set for a significant recovery by the Russell 2000 Index into spring.
Technical influences
The Russell 2000 Index currently has a negative technical profile, but is showing early signs of bottoming. Intermediate trend is down. The Index trades below its 200 day moving average. However, the Index has just moved above its 50 day moving average and its short term momentum indicators (Moving Average Convergence Divergence, Relative Strength Index and Stochastics) are recovering from oversold levels. Strength relative to the S&P 500 Index turned positive in the fourth week in November. Intermediate support is indicated at 371.30. Short term resistance is indicated at 491.78.
Fundamental influences
Recent weakness in the U.S. Dollar Index is a bonus for companies that are included in the Russell 2000 Index. Russell 2000 companies mainly are smaller companies that focus on U.S. markets instead of international markets. Weakness in the U.S. Dollar will help them to compete more effectively with international companies that import their goods and services into U.S. markets.
What to do?
Several small cap Exchange Traded Funds (ETF) are available. The most actively traded small cap ETF is iShares on the Russell 2000 Index (Symbol: IWM). Canadian investors can choose to purchase a hedged version by owning iShares on the Canadian Russell 2000 Index (Symbol: XSU). Units trade in Canadian Dollars and are fully hedged against a decline in the U.S. Dollar.
Don Vialoux, Chartered Market Technician is the author of a free daily report on equity markets, sectors, commodities, equities and Exchange Traded Funds. Reports are available at www.timingthemarket.ca . Mr. Vialoux does not own small cap U.S. Exchange Traded Funds mentioned in this report.
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