Persons of a certain demographic will well remember the old Steve Martin bit (back when he was a comedian and not an actor) about how he liked to “get small.”  All other demographics will simply shrug their shoulders and say “huh.”  Either way, there is still that popular old adage that states that “bigger is better.”  And for the most part that is probably true. Of course, sometimes people try to take a potshot at popular notions. Hence the counter-phrase, “the bigger they are, the harder they fall.”  Yeah, take that, big. Of course, anyone who has ever played a contact sport knows that the correct phrase is actually “the bigger they are, the harder they hit.”  But I digress.

The point I really wish to make is this: while “big” has certain inherent advantages over “small” (like size, for instance), the truth is that bigger is not always better. This is true in life (go ahead, let’s see you parallel park that Chevy Suburban); it is also true in the stock market. There is a time for small (caps) and a time for large (caps). The trick is to know when to move from one to the other.

LARGE VERSUS SMALL

To answer this question I will turn once again to the Hirsch Organization’s wonderful “Stock Traders Almanac.”  The 2007 edition will mark the fortieth year of publication for this outstanding compendium of interesting and useful stock market trends. I typically prefer to do my own research but I am always looking for useful information. So when it falls into my lap, what am I supposed to do?  I figure, give credit where credit is due and move on. So thank you, Hirsch Organization.

The trend that I am going to talk about involves comparisons between the Russell 1000 Index (RUI), a large-cap index which closely mirrors the S&P 500 (the correlation between the RUI and SPX is about 0.994 with 1.000 meaning they trade exactly the same), and they Russell 2000 (RUT), a small-cap index. So from this point forward if I say:

- “large-cap” I am referring to the symbol RUI

- “small-cap” I am referring to the symbol RUT

- “RUI” I am referring to large-cap stocks

- “RUT” I am referring to small-cap stocks

I only have data for both of these indexes since 12/31/88, which is not really enough history to be statistically significant. Still, since the Hirsch test goes back to 1979 we will assume that the post-1988 results are similar to those experienced in previous years.

IT’S ALMOST TIME TO “GET SMALL”

To illustrate the power and consistency of “the little guy” during this time of year, let’s first look just at the time frame extending from the close of trading on 12/15 through 12/31 each year.

Table 1 displays the performance of the RUT and the RUI indexes each year since 1989 between 12/15 and the end of the year.

Table 1 – Small-cap versus large cap during 2^nd half of December

Chart 1 shows the growth of $1,000 during the December 15^th - December 31^st timeframe since 1989 for the RUT and the RUI. These results clearly illustrate the tendency for small-caps (RUT) to outperform large-caps during this timeframe (RUI).

Chart 1 – Growth of $1,000 invested in Small-Caps (blue line) versus Large-Caps (purple line) December 15th through December 31^st since 1989

A few notes of interest:

- The RUT has advanced 15 of the last 17 years between 12/31 and the end of the year.

- The RUT performed as well or better than the RUI during 13 of those 17 years.

- The average gain for the RUI during this yea-end period was +3.4%. While this may not sound significant to some, remember that we are talking about a +3.4% gain in a half a month. This works out to an annualized return of about +120%. If only it really were Christmas all the time!

- $1,000 invested only in the RUT during the second half of December would have grown to $1,738 versus just $1,378 if invested only in the RUI during the same time.

AN ANNUAL STRATEGY

Now let’s look at another interesting trend regarding small-caps vis-a-vis large caps. As we have already seen, there do appear to be periods when one group might fairly consistently outperform the other. So let’s look at another such trend. It has been suggested that small–caps tend to outperform large-caps from mid-December through the end of the following February. Large-caps tend to outperform the rest of the time. Is there anything to this claim?  And if so, is there a way to use it to make money? Let’s take a look. 

December 15 through February

Chart 2 displays the growth of $1,000 invested in RUT and RUI, respectively only between December 15^th and the end of February each year. Note that small-caps clearly outperform.  

Chart 2 – Small-cap (purple line) versus large-cap (blue line) from 12/15 through end of following February since 1988 – Note that small-caps outperform large-caps

February through December 15^th

Chart 3 displays the growth of $1,000 invested in RUT and RUI, respectively only between the end of February and December 15^th each year. Note that large-caps clearly outperform.

Chart 3 - Small-cap (purple line) versus large-cap (blue line) end of February through 12/15 since 1988 – Note that small-caps underperform large-caps.

Now let’s combine these two strategies. Let’s assume that we will be long small-caps from the close on 12/15 through the end of the following February and then switch into large-caps at the end of February and hold them through the following 12/15.  

Chart 4 displays the equity curve for this switching strategy versus a buy-and-hold approach that simply split $1,000 evenly between RUI and RUT on 12/31/88.

Chart 4 – Blue line = Hold small-caps 12/15 through Feb 28. Purple line = Split money evenly between small-cap and large-cap

The bottom line:

Switching: $1,000 grows to $8,450
Splitting: $1,000 grows to $5,163
Opposite $1,000 grows to only $3,154
(“opposite” strategy involves holding large-caps from 12/15 through 2/28 and small-caps from 2/28 through 12/15):

Chart 5 displays our proposed strategy (long small-caps 12/15 through 2/28 and long large-caps the rest of the year) versus the opposite strategy (long large-caps 12/15 through 2/28 and long small caps the rest of the year). The disparity in performance is fairly obvious.

Chart 5 – Proposed Strategy (purple line) versus inverse strategy (blue line)

SUMMARY

So are small-cap stocks guaranteed to outperform large-cap stock for a while after December 15^th?  Sadly, the answer is no. One problem with seasonal tendencies is that sometimes they work and sometimes they don’t. And because many of them don’t come around often, when a trader tries to use one and it doesn’t happen to work that time around, they tend to dismiss it in the future. And that is the other problem with seasonal tendencies - although they are typically consistent and profitable, most investors don’t have the patience to stick with them for the long haul. Mores the pity.

Now, if you will excuse, I’m gonna get “real small.”


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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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