Signs point to strong winter U.S. small-cap rally

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Don & Jon Vialoux, Financial Post · Saturday, Dec. 11, 2010

Small capitilization U.S. indices have a history of outperforming big capitalization indices from the middle of December to at least the end of February. Will the "Small Cap Effect" happen again this year?

Thackray's 2011 Investor's Guide notes that the Russell 2000 Index outperforms the Russell 1000 Index from Dec. 19 to March 7. The Russell 2000 Index has gained in 24 of the past 31 periods for an average gain per period of 5.6 %. It also outperformed the Russell 1000 Index by an average of 3.5% per period.

Small-cap equities and exchange-traded funds tend to come under pressure during October, November and early December each year due to a series of annual recurring events.

Tax-loss selling pressures by individual investors take their toll during this period. In addition, "window dressing" by institutional investors has a negative influence. Institutional investors prefer not to show large holdings in "high beta" small-cap stocks when they release their annual reports. As well, institutional investors, who are having a profitable year, often prefer to own big-cap stocks with lower volatility near year end as the time for calculating their final performance bonus approaches.

Weakness until mid-December normally sets the stage for a significant recovery in the sector near year end. Frequently, the recovery starts during the traditional Santa Claus rally period from Dec. 15 to Jan. 6, when tax-loss selling pressures are relieved. In addition, institutional investors start to look for equities with higher risk and greater potential return to set the stage for potential outperformance in the following year.

Frequently, top candidates are found within the small-cap sector.

Small caps are showing strength earlier than usual this year. Last week the Russell 2000 Index broke resistance at 745.95 to reach a three-year high. Strength relative to the S&P 500 Index has been positive since mid-August. Short-term momentum indicators currently are overbought. Preferred strategy is to buy the sector on weakness.

The small-cap sector is in a better position for earnings growth in 2011 than the big-cap sector. Equities with smaller capitalizations benefit more from low short-term U.S. interest rates.

The Federal Reserve's current "Quantitative Easing II" program assures that low short-term rates will continue into the first half of 2011.

In addition, President Obama's tax-cut extension proposal announced last Monday favours domestic based small-cap companies over internationally based large-cap entities. The proposal was designed to encourage employment and production at an extended low tax rate on U.S.-based income.

Several small-cap exchange-traded funds (ETFs) are available. The most actively traded U.S. small-cap ETF is the iShares Russell 2000 Index (IWM/NYSE).

Canadian investors can choose to purchase a hedged version by owning the iShares Russell 2000 Index Fund (CAD-hedged) (XSU/ TSX). Units trade in Canadian dollars and are fully hedged against a decline in the U.S. dollar.

In addition, iShares offers the S&P/TSX SmallCap Index Fund (XCS/TSX), consisting of 211 Canadian stocks in the TSX Composite Index.

Read more: http://www.financialpost.com/tod ... .html#ixzz17psXpBNo

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