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An Update On The Small Cap Effect


Small cap U.S. indices such as the Russell 2000 Index have a history of outperforming big cap indices such as the S&P 500 Index from the middle of December to early March. What happened to the “Small Cap Effect” this year?

Seasonal influences

Thackray’s 2010 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 30 periods for an average gain per period of 5.4 percent and outperformed the Russell 1000 Index by an average of 3.4 percent per period.

Small cap equities and Exchange Traded Funds tend to come under pressure during October, November and early December each year due to a series of annual recurring events. Tax loss selling pressures by individual investors take their toll during this period. In addition, “window dressing” by institutional investors has a negative influence. Institutional investors prefer not to show large holding is small cap stocks when they release their annual reports. Accordingly, they tend to replace many of their small cap holdings with big cap holdings as year end approaches.

Weakness until mid December sets the stage for a significant recovery by the small cap sector near year end. Frequently, the recovery starts during the traditional Santa Claus rally period from December 15th to January 6th. Tax loss selling pressures are relieved. In addition, institutional investors start to look for equities with higher risk, but greater potential return to set the stage for potential outperformance in the following year.

Frequently, they find securities within the small cap sector.

What happened this year? Window dressing late last year was more intense than usual. Institutional investors were caught with large cash positions near the end of the third quarter despite strong equity markets from March to September. They responded by parking cash positions in big cap equities and Exchange Traded Funds until near yearend. Big cap equity indices such as the Dow Jones Industrial Average and the S&P 500 Index significantly outperformed small cap equity indices such as the Russell 2000 Index from October 1st to December 1st. The S&P 500 Index gained 7.7 percent and the Dow Jones Industrial Average added 10.1 percent while the Russell 2000 Index improved only 0.9 percent. The stage was set for rotation from overvalued big cap positions to undervalued small cap positions. Since December 19th when our column on this topic was published in the Financial Post, the S&P 500 Index gained 3.9 percent while the Russell 2000 Index increased 10.5 percent.

Technical influences

Technical parameters suggest that the seasonal move by small cap indices and related Exchange Traded Funds (ETFs) is not over yet. Intermediate trend for the Russell 2000 Index remains up. Short term momentum indicators including Moving Average Convergence Divergence, Relative Strength Index and Stochastics are substantially overbought, but have yet to show technical signs of rolling over. Investors, who entered the trade as a seasonal play, are watching technical indicators closely for an opportunity to fine tune their exit.


What to do?

Look for an opportunity to take seasonal profits in favoured Exchange Traded Funds when short term technical indicators show signs of rolling over. Several small cap ETFs were mentioned favourably in the December 19th column including iShares on the Russell 2000 Index (Symbol: IWM), the most actively traded small cap ETF. Canadian investors also may have chosen 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. In addition, iShares on a small cap Exchange Traded Fund consisting of Canadian stocks in the TSX Composite Index (Symbol:XCS) were mentioned.

Stocks mentioned in this post: , ,


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