Veteran small-cap stock investors may be bracing themselves for pain in the last two months of the year. But in 2019, at least, things might not turn out so bad.
Traditionally, small- and large-cap stocks have tended to take divergent paths as the year closes. “The smallest stocks tend to turn in their best returns in January, and their returns thereafter deteriorate—with that deterioration picking up steam at year’s end,” explained Wall Street Journal columnist Mark Hulbert in a recent article. “In contrast, the largest stocks tend to be weakest in January and strongest at year end.”
According to Hulbert, the 10% of stocks with the smallest market caps see a 3.2-percentage-point decline in average monthly return from the first to the fourth calendar quarters — a pattern that’s held since 1926. In contrast, the top 10% of stocks in terms of market cap saw a 0.5-percentage-point increase.
Citing Professors Lucy Ackert of Kennesaw State University and George Athanassakos from the University of Western Ontario, who documented the pattern in a 2000 paper published in the Journal of Business Finance & Accounting, Hulbert said the trend reflects a tendency toward gamesmanship in investing.
“As year-end approaches, institutional investors who are ahead of the market have an incentive to make their portfolios increasingly look like the S&P 500 to lock in their relative year-to-date returns,” he said. Doing so puts them on track to be recognized as market-beaters at the end of the year — at which point they can collect a handsome year-end bonus for their achievement.
“So these managers will sell their small-cap holdings as the end of the year nears, and replace them with the large-cap stocks that dominate indexes such as the S&P 500,” Hulbert said.
But an interview with Ackert, Hulbert said, suggests that the motivations to do so this year seem to be weaker. In years that see particularly strong stock-market performance from January to October, managers are under less pressure to beat the market, as they are likely to have produced strong gains anyway. That means they’re less likely to trade in their small-cap holdings for large-cap members of the S&P 500.
The opposite tends to be true in bear-market years, when managers are keener to show clients that while they may have lost money, they still did better than a broad market index fund. In such situations, there’s a greater temptation to swap out the smallest stocks for large-cap alternatives.
With a weaker forecast of small-cap doldrums, Hulbert said, investors should hold on to their smallest stocks through the end of the year. “[I]t is crucial to be invested in small-cap stocks in January, and those who get out now often fail to get back in on time,” he said.
Based on records from the Fama-French database, he said January has held the record for being the best month for the smallest stocks since 1926. Regardless of whether the previous year was particularly good or bad for the overall stock market, the 10% of stocks with the most miniscule market caps — often referred to as microcap — have produced an average gain of 7.3%, equating to annualized gains of over 100%.
“For the other 11 months of the calendar, their average annualized gain is less than for the average largest-cap stock,” Hulbert said. “[I]t means that there is no small-cap advantage, on average, from February through December.”
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