New Year Promising For Small Stocks

SATURDAY, DEC. 28, 1996

With the Russell 2000 small stock index up 12.5 percent this year, investors in small stocks are hardly suffering a case of the holiday blues. Still, they have fared poorly in comparison to investors in big stocks, which have soared nearly 9 percentage points more.

But the tables are ready to turn because of the “January effect” - the tendency of small stocks to outperform the rest of the market in the first few weeks of a new year.

Individuals own a large proportion of the outstanding shares of small stocks, including small technology issues, and those stocks tend to rise briskly in the aftermath of year-end tax-loss selling. Sometimes small stocks fail to outperform; they lagged big stocks last January, for example. But market pros say the trend should resurface next month because of the unusually big gap in performances by the big fry and the small fry, and because of widespread expectations that small-company earnings will grow more than twice as much as big-company earnings in 1997.

Moreover, economic growth is expected to be tepid, favoring companies that chase niche markets over bigger companies whose fortunes tend to rise and fall with the overall economy.

“I wouldn’t be surprised to see a 5 percent jump in small stocks in January and even more in small-technology and health-care stocks,” says David Colville, executive editor of Walnut Creek-based OTC Insight. “This time, the January effect is all but inevitable.”

Market watchers say many small stocks were sold for relatively minor losses this year. It’s not that investors have lost faith in them. Rather, experts say that investors have been looking for whatever losses they can find to offset the capital-gains taxes incurred from cashing in outsized gains in large stocks.

Selling “impacts small stocks the most because they are less liquid,” says Stephen Leeb, editor of Personal Finance.

Small-stock values are compelling. Colville says the price/earnings multiple of the Russell 2000 is 0.95 percent of the S&P; 500, down from a norm of 1.15 percent to 1.2 percent. Even more impressive is the comparative price-to-book ratio, or the share price divided by net assets per share. Today, the price-to-book of the Russell 2000 is 70 percent of the S&P;’s - down from a long-time average of 90 percent and the lowest ratio since 1979.

Market gurus say the January effect should become most apparent the week of Jan. 6, the first postholiday business week, and mutual funds are expected to join the action. Fund shareholders, not funds themselves, pay capital-gains taxes. But mutual funds are sensitive to shareholders’ tax burdens. So funds also sold modest losers before the end of their October fiscal years to trim what shareholders must pay Uncle Sam. Funds commonly snap up the same shares at lower prices in January, after individual investors have beaten down prices further.

A few market experts, such as Richard Davis Jr., research director of Dallas-based Rauscher Pierce Refsnes, note that the January effect has been absent or subdued in the last two years and argue that it’s dead. “The market is very efficient,” Davis says. “Once some investors recognize an edge, everybody recognizes it, and it disappears.”

Moreover, the significance of individual investors has dwindled in the face of the explosive growth of mutual funds, Davis says.

But his views are in the minority. The market is efficient, but not that efficient, other investment pros say, partly because of chronically sharp disagreements about investment trends. And while individual investors may no longer rule the roost, they still account for nearly 50 percent of stock market trading volume. According to the National Association of Investors Corp., there are more than 26,000 investment clubs nationwide, more than a fourfold increase throughout the past decade.

Click here to comment on this story »