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Small caps vs. large caps: Trading the “January effect”

  • By Jeffrey A. Hirsch,
  • Wiley Global Finance WILEY GLOBAL FINANCE
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Stocks are typically grouped into three or four categories based on their market valuation or capitalization, i.e. “market cap:” Market cap is calculated simply by multiplying the current price of the stock by the number of shares of stock that have been issued by the underlying company. There is no official definition or dollar value level for the four major market cap categories. They vary over the years and from entity to entity. But generally, large cap stocks have market valuation of $5 billion or more, mid caps are between $1 billion and $5 billion, small caps are under $1 billion, and micro caps are under $100. For example, if company XYZ’s stock trades at $20 per share and it has issued 25 million shares, it has a market cap of $625 million and would be considered a small cap stock.

It is has been reported that the “January Effect” was first identified by economist and investment banker Sidney Wachtel. Mr. Wachtel studied the seasonal movements in the stock market and is believed to have coined the term “January Effect.” He detailed his research in his 1942 paper, “Certain Observations on Seasonal Movements in Stock Prices,” which appeared in the Journal of Business published by the University of Chicago Press. The theory and pattern was that U.S. stock prices outperformed in January and that small caps outperformed large caps in January. The January Effect phenomenon was likely caused by yearend tax loss selling of small cap stocks, driving their stock prices down. These bargain stocks are often bought back in January with the help of yearend bonus payments in January.

Over the years we reported annually on the fascinating January Effect showing that Standard & Poor’s Low-Priced Stock Index during January handily outperformed the S&P 500® Index 40 out of 43 years between 1953 and 1995. Small caps on average quadrupled the returns of large caps in this period. Then, the January Effect disappeared over the next four years. S&P decided to discontinue their Low-priced index, so needed a substitute. With the advent of the Russell Indices in 1984, a consistent, convenient benchmark was created, the Russell 2000® index of small cap stocks. This index consists of the 2000 companies with the smallest market caps within the Russell universe of the 3000 largest U.S. firms. This index is our preferred small-cap benchmark used in the Stock Trader’s Almanac.

Small Caps Begin to Blossom in Late October

The tendency of small-cap stocks to outperform big caps, known as the “January Effect,” is clearly revealed in Figure 1. Thirty-four years of daily data for the Russell 2000 index of smaller companies are divided by the Russell 1000® index of largest companies, and then compressed into a single year to show an idealized yearly pattern. When the line on the chart is descending, large caps are outperforming small caps; when the line on the chart is rising, small cap are moving up faster than large caps.

In a typical year the small cap stocks stay on the sidelines while the large caps are on the field. Then, around late October, small stocks begin to wake up and in mid-December, they take off. Anticipated year-end dividends, payouts and bonuses could be a factor. Other major moves are quite evident just before Labor Day—possibly because individual investors are back from vacations—and off the low points in late October and November. Small caps hold the lead through the beginning of May.

FIGURE 1 Russell 2000/1000 One-Year Seasonal Pattern Chart

For a longer term perspective we have compared the actual ratio of the Russell 2000 divided by the Russell 1000 from 1979. See Figure 2. Smaller companies had the upper hand for five years into 1983 as the last major bear trend wound to a close and the nascent bull market logged its first year. After falling behind for about eight years, they came back after the Persian Gulf War bottom in 1990, moving up until 1994 when big caps ruled the latter stages of the millennial bull. For six years the picture was bleak for small caps as the large caps and tech stocks moved to stratospheric PE ratios. Small caps spiked in late 1999 and early 2000 and reached a peak in early 2006, as the four year old bull entered its final year. Note how the small cap advantage has waned during major bull moves and intensified during weak market times. Look for a clear move lower to confirm a major bull move is in place.

Figure 2 Russell 2000/1000 Monthly Closes Chart

Small-Cap Advantage, By the Numbers

Figure 1 shows small cap stocks beginning to outperform the large caps in mid-December. Narrowing the comparison down to half-month segments is quite revealing, as you can see in Table 1.

Table 1: 25 and 33 Year Average Rate of Return

25 year average rates of return (Dec 1987-Feb2012)
From Russell 1000 Russell 2000
Mid-Dec* Change Annualized Change Annualized
12/15-12/31 1.9% 53.9% 3.5% 119.9%
12/15-1/15 2.4% 31.2% 4.2% 60.2%
12/15-1/31 2.7% 24.2% 4.4% 41.9%
12/15-2/15 3.7% 24.4% 6.2% 43.5%
12/15-2/28 3.0% 16.1% 6.0% 34.1%
End-Dec*
12/31-1/15 0.4% 8.7% 0.5% 11.0%
12/31-1/31 0.5% 6.2% 0.7% 8.7%
12/31-2/15 1.4% 11.6% 2.2% 18.7%
12/31-2/28 0.7% 4.5% 1.9% 12.6%
33 year average rates of return (Dec 1979-Feb 2012)
From Russell 1000 Russell 2000
Mid-Dec* Change Annualized Change Annualized
12/15-12/31 1.7% 47.1% 3.0% 96.8%
12/15-1/15 2.4% 31.2% 4.4% 63.8%
12/15-1/31 2.7% 24.2% 4.7% 45.3%
12/15-2/15 3.4% 22.2% 6.1% 42.7%
12/15-2/28 2.9% 15.2% 6.0% 33.4%
End-Dec*
12/31-1/15 0.7% 15.8% 1.3% 31.2%
12/31-1/31 1.1% 14.0% 1.6% 21.0%
12/31-2/15 1.8% 15.1% 3.0% 26.2%
12/31-2/28 1.3% 8.3% 2.9% 19.2%

* Mid-month dates are the 11th trading day of the month, month end dates are monthly closes

Small-cap strength in the last half of December became even more magnified after the 1987 market crash. Note the dramatic shift in gains in the last half of December during the 25-year period starting in 1987, versus the 33 years from 1979 to 2012. With all the beaten down small stocks being dumped for tax loss purposes, it generally pays to get a head start on the January Effect in mid-December. You don’t have to wait until December either; the small-cap sector often begins to turnaround toward the end of October and November.

Wall Street’s Only “Free Lunch”

Investors tend to get rid of their losers near year-end for tax purposes, often hammering these stocks down to bargain levels. Over the years we have shown in the Stock Trader’s Almanac that NYSE stocks selling at their lows on December 15 will usually outperform the market by February 15 in the following year. (Preferred stocks, closed-end funds, splits and new issues are eliminated.) When there are a huge number of new lows, stocks down the most are selected, even though there are usually good reasons why some stocks have been battered.

Table 2: Bargain Stocks versus The Market*

Short span* New lows % Change % Change Bargain stocks
Late Dec-Jan/Feb Late Dec Jan/Feb NYSE Composite Advantage
1974-75 112 48.9% 22.1% 26.8%
1975-76 21 34.9% 14.9% 20.0%
1976-77 2 1.3% –3.3% 4.6%
1977-78 15 2.8% -4.5% 7.3%
1978-79 43 11.8% 3.9% 7.9%
1979-80 5 9.3% 6.1% 3.2%
1980-81 14 7.1% -2.0% 9.1%
1981-82 21 -2.6% -7.4% 4.8%
1982-83 4 33.0% 9.7% 23.3%
1983-84 13 -3.2% -3.8% 0.6%
1984-85 32 19% 12.1% 6.9%
1985-86 4 -22.5% 3.9% -26.4%
1986-87 22 9.3% 12.5% -3.2%
1987-88 23 13.2% 6.8% 6.4%
1988-89 14 30.0% 6.4% 23.6%
1989-90 25 -3.1% -4.8% 1.7%
1990-91 18 18.8% 12.6% 6.2%
1991-92 23 51.1% 7.7% 43.4%
1992-93 9 8.7% 0.6% 8.1%
1993-94 10 -1.4% 2.0% -3.4%
1994-95 25 14.6% 5.7% 8.9%
1995-96 5 -11.3% 4.5% -15.8%
1996-97 16 13.9% 11.2% 2.7%
1997-98 29 9.9% 5.7% 4.2%
1998-99 40 -2.8% 4.3% -7.1%
1999-00 26 8.9% -5.4% 14.3%
2000-01 51 44.4% 0.1% 44.3%
2001-02 12 31.4% -2.3% 33.7%
2002-03 33 28.7% 3.9% 24.8%
2003-04 15 16.7% 2.3% 14.4%
2004-05 36 6.8% -2.8% 9.6%
2005-06 71 12.0% 2.6% 9.4%
2006-07 43       5.1% -0.5% 5.6%
2007-08 71 -3.2% -9.4% 6.2%
2008-09 88     11.4% -2.4% 13.8%
2009-10 25 1.8% -3.0% 4.8%
2010-11 20 8.3% 3.4% 4.9%
2011-12 65 18.1% 6.1% 12.0%
38 year totals 481.1% 119.5% 361.6%
Average 12.7% 3.1% 9.5%

* Dec 15 - Feb 15 (1974-1999), Dec 1999-2012 based on actual newsletter advice.

In response to changing market conditions we tweaked the strategy the last 13 years adding selections from NASDAQ, AMEX and the OTC Bulletin Board, and selling in mid-January some years. We have come to the conclusion that the most prudent course of action is to compile our list from the stocks making new lows on Triple-Witching Friday before Christmas, capitalizing on the Santa Claus Rally. This also gives us the weekend to evaluate the issues in greater depth and weed out any glaringly problematic stocks.

This “Free Lunch” strategy is only an extremely short-term strategy reserved for the nimblest traders. It has performed better after market corrections and when there are more new lows to choose from. The object is to buy bargain stocks near their 52-week lows and sell any quick, generous gains, as these issues can often give up these bounce-back gains immediately.

Jeffrey A. Hirsch is editor-in-chief of the Stock Trader's Almanac and Almanac Investor newsletter, and the author of The Little Book of Stock Market Cycles (Wiley, 2012).

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Article copyright ©2012 by Jeffrey A. Hirsch. Adapted from the Stock Trader’s Almanac with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.
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