January's Bullish News For Small-Caps

By Aaron Levitt | January 11, 2011 AAA

With the new year underway, signs are already pointing to another bullish year for stocks. The improving global macroeconomic picture has many analysts and strategists predicting banner results for equities, commodities and emerging markets. A broad based fund like the Vanguard Total World Stock Index ETF (NYSE:VT) might be enough for investors to take advantage of this trend. However, a certain sector combined with a seasonality pattern maybe the best way to play the upcoming year.
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Year-End Tax Selling
A curious thing happens in the stock market around the end of one year and beginning of the next. Many institutional money managers sell-off losers in their portfolios in December to take advantage of tax losses. Many managers reestablish positions in the new year, resulting in a rally in equity prices. These capital gains offsets combined with the general bullish euphoria of the start to the new year are known as the January Effect. (For related reading, see January Effect Revives Battered Stocks.)

However, this seasonal anomaly affects stocks of various market-caps quite differently. For investors looking at large-caps, January shows no real statistical difference between other months of the year. For investors looking at smaller companies, January proves to be your month. Research conducted by famed economic duo of Fama & French shows that small-cap stocks tend to experience most of their positive returns in the month of January. Since 1926, small-caps have beaten their larger cousins by nearly 7% on average in January. This has held true even in the last two years of the global credit crisis. What's more exciting is that this January boost is what has helped small-caps traditionally outperform larger companies over the long haul. Without it, small-caps perform roughly at the same rate.

In addition, small-caps have performed well in the first two years of a new bull market. Typically, during year one, they beat the market about 90% of time. During the second year, its 60% of the time.

Taking Advantage
For investors wanting to take advantage of this jolt in small-cap prices now is the time to act. The January effect typically only lasts for about three or so weeks. Investors, however, may want to bypass the popular iShares Russell 2000 Index (NYSE:IWM). The average market-cap of the ETF's holdings is in the $1 billion range. Top holding Riverbed Technology (Nasdaq:RVBD) has a market cap of nearly $6 billion. This market-cap range is well above what Fama & French describe in their research. A better choice maybe the iShares S&P Small Cap 600 Value Index (NYSE:IJS) with its max market-cap at only $2.41 billion.

An even better way to play the seasonal small-cap shot in the arm is through the tiniest of companies. Fama & French's research shows that those companies with market caps of less than $250 million outperform even more. Following the smallest of small, the PowerShares Zack's Micro Cap (NYSE:PZI) tracks about 400 micro-cap stocks including software developer Smith Micro Software Inc. (Nasdaq:SMSI) and specialty chemical producer Quaker Chemical Corporation (NYSE:KWR). Similarly, investors can use the iShares Russell Microcap Index (NYSE:IWC) with its average market cap of only $275 million.

Bottom Line
With 2011 shaping up to be another great year for stocks, investors may want to take advantage of the seasonality phenomena known as the January Effect. Year-end tax selling and optimism about the next 12 months bodes well for smaller companies. By adding or increasing exposure to small-caps during the first month of the year, investors can profit. The aforementioned micro-cap ETFs as well as the First Trust Dow Jones Select MicroCap (NYSE:FDM) are a great way to add that portfolio weighting.

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