Small-Cap Stocks Shift Gains Into December Astute Traders Beat ‘January Effect’ With Early Investments

This is about something hot in December - small-company stocks, to be specific - and it comes straight from January.

It is about the so-called January effect, in which small-capitalization stocks in that month seem to carry a premium over the larger issues. The effect has been observed for years, and it continues to this day.

To illustrate: During the past 50 years, small-caps have posted gains during 40 Januaries, with the monthly return averaging nearly 6 percent, which you must agree is a wonderful way to start the new year.

In fact, some of the best gains have been made in recent Januaries, a performance that arouses doubts about one of the oldest of Wall Street maxims, that when a strategy becomes well known it loses its effectiveness.

While the effect retains its potency, there has been a change: It has been moving up into December, a result, it is theorized, of traders seeking to assure themselves of maximum gains by buying low and early.

“It gets earlier and earlier,” says Michael Corbett, who has followed and analyzed the phenomenon as one of the Investment Information Services team founded by ex-mathematics professor Gerald Perritt.

Perritt’s interest in the subject followed research in 1978 by Rolf Banz of the University of Chicago, who found small stocks tended to outperform the largest stocks, even when adjusted for higher risks.

One of the qualifiers is that the small-cap effect seems to phase in and out - underperforming and outperforming the big-name stocks - over periods of perhaps seven to nine years.

The current phase, dating from late 1990, has been one of superior performance, with small-cap stocks returning 18 percent annually since 1991, compared with 15.5 percent for larger stocks.

While the difference might not seem large at a casual glance, it is. In fact, with the impact of compounding it can make a huge difference, amounting to tens of thousands of dollars for even small portfolios over the years.

The January in December effect, therefore, is an effect within an effect. Small-caps can deliver superior returns for years at a time, and small-caps can be especially rewarding during December and January.

In fact, says Mark Hulbert of The Hulbert Financial Digest, the latter effect is so persistent it “constitutes a major exception to the Efficient Market Hypothesis that the market can’t consistently be beaten over time.”

But what is a small-cap stock? According to Perritt, a small-cap stocks is defined properly as a company with a market value below that of the company that divides the top 80 percent (based on market value) of New York Stock Exchange listings from the bottom 20 percent.

That definition recently distilled the small-cap universe to about 2,000 companies with maximum market valuations below $160 million.