Dow 18,000 may be stealing headlines this week, but it will be smaller stocks’ time to shine in January.
Small capitalization stocks — loosely defined has having a market value less than $1 billion — are primed to ride a January Effect seasonal tailwind, along with lower gas prices, to big gains versus their large-cap peers to start 2015, investors and analysts said.
It’s been a big-cap world in 2014. The Dow Jones industrial average is up 9 percent and the S&P 500 is up 13 percent. Meanwhile, the Russell 2000 — the small-cap benchmark — is up just 3.5 percent. But that’s starting to change.
The Russell is up more than 2 percent in the last month, greater than a one percent rise in the S&P 500.
Wall Street started trading the so-called January Effect sometime near the start of the 1980s. The effect refers to investors’ selling smaller stocks out of their portfolios at the end of the year in order to take tax losses. They then buy back the shares in the new year.
As the trend became more popular, the phenomenon began happening earlier in December with the lift in small caps actually occurring before the start of the next year. So the group’s recent outperformance should come as no surprise.
“After a year of consolidation, the setup on the RTY (Russell 2000) looks much more attractive to us than at any point in the last six-nine months,” wrote Jonathan Krinsky, chief market technician for MKM Partners in New York. Based on historical patterns, he projects a rally of 12 to 13 percent for the small cap index.
A chart by Krinsky in his report shows the small-cap outperformance over the S&P 500 clearly occurring not only in January, but in the first three months of the calendar year.
“Small stocks underperformed from March through October of 2014 and have been performing inline or gaining since,” said John Bollinger, who wields his famous Bollinger Band analysis for the web site www.BBands.com. “I suspect that next year could be a pretty good year for small stocks.”
There are three fundamental factors in small caps’ corner heading into the new year, according to investors. First, small caps get the majority of their revenue domestically, and falling gas prices should give quite a boost to spending by the U.S. consumer.
Second, an eight-year high for the dollar will be a headwind for big caps trying to sell their goods internationally.
And third, slowing global growth in key areas such as China and Europe will also hit big cap exporters.
CNBC validated the January Effect through analysis using Kensho, a quantitative analytics tool used by hedge funds to make buying and selling decisions. Over the last 25 years, the Russell 2000 Index averaged a 0.65 percent increase during January, while the S&P 500 posted a 0.29 percent gain in the first month, according to Kensho.
So what’s the best way to play the January Effect?
CNBC looked at more recent history (the last 10 years) to see if there are some repeat January small-cap winners.
Biotech services company Parexel International rose each of the last 10 Januarys, according to Kensho, posting an average 15 percent gain. Knightsbridge Shipping has a perfect January track record, as well, averaging a 9 percent gain.
Homebuilder Ryland Group is up 9 of the last 10 Januarys, posting an average jump of 9 percent.
CNBC’s parent NBCUniversal is a minority investor in Kensho.