Alpha Power Investing Newsletter

July 13, 2010

Small Cap Peril and Opportunity

When investors feel like speculating, they move to small-cap stocks. In good markets, small-caps can deliver outsized gains very quickly. On the other hand, when investors are nervous, small-cap stocks are the first to go.

As a result, small-cap stocks feel the annual summer slump (caused by the forecasting cycle) more profoundly. The period between July 1 and November 1 is especially dangerous - it is the small-cap "dead zone".

The Russell 2000 Index, which covers the 2000 smallest companies in the Russell equity universe of 5000 stocks, was created in 1979. Since its inception, there have been 31 "dead zones", of which 17 were down. A hypothetical investor beginning with $100,000 in 1979, investing in the Russell 2000 only during the four-month "dead zone", would now have $53,500. This represents an annual return of -2.0%. Over the course of 31 years, there have been several of these four-month periods which have been game-changers:

1981: -10.6%
1983: -11.5%
1987: -27.7%
1990: -29.0%
1998: -16.9%
2001: -16.2%
2002: -18.9%
2008: -21.7%

This cycle is not written in stone. After all, the small-cap "dead zone" has been up 14 times since 1979. It was up 11.2% in 2009, for example. Nevertheless, the lesson for long-term investors who are focused on risk management is pretty obvious; namely, avoid the "dead zone" and come back in late-October.

The small-cap "dead zone" is caused by the annual forecasting cycle. The cycle begins late in the year, when earnings analysts tend to be overly optimistic about the next calendar year. This optimism normally translates into strong returns in November and December. By mid-year, analysts tend to lower their full-year estimates for the companies they follow. Investors become nervous and begin shedding their riskiest holdings - small-cap stocks.

The "dead zone" sets up one of the best investment bets available to conservative, risk-managed portfolios. As the market recovers from the annual forecasting slump, and as analysts put forth their glowing estimates for the next year, investors begin moving once more into small caps. In December, for example, the Russell 2000 has an average return of about 3%, twice the average return of the S&P 500.

During the fourth quarter, there are three periods when small-cap returns are extremely robust and exceptionally consistent:

  1. The last 2 trading days of October and the first 2 trading days of November. This period has been up 87% of the time since 1979, averaging a return of 2.0%*.
  2. The last 6 trading days of November and the first 3 trading days of December. This period has been up 87% of the time since 1979, averaging a return of 2.1%*.
  3. The last 7 trading days of December. This period (the Santa Claus Rally), has been up 93% of the time since 1979, averaging a return of 2.3%*.

Overall, these three periods in combination have averaged an annual total return of 6.5%* over 20 days of market exposure since 1979, and have suffered only two nominal losses in 31 years (-0.6% in 2006, -1.0% in 1984).

Now let's suppose you are a very conservative investor. While risk management is your primary concern, you also know that your assets have to grow in excess of inflation to stay ahead of the game. Somehow you have to incorporate a growth machine into your investment equation.

Well, now you have it. By investing in small-cap stocks for just 20 days each year, you can add a highly reliable "equity kicker" to your portfolio. To see how this works in detail, go to the Programs section at www.alphaim.net and read about the ALPHA Bonds Strategy. I don't think you'll find a more consistently robust investment strategy anywhere.

The ALPHA Bonds Strategy is available tax-deferred for taxable accounts for an additional $20 a month (not available to Ohio residents). Please contact me for details.

Sincerely,
Jerry Minton, Ph.D.
President

*Past performance is not a guarantee of future performance.

© 2010 Alpha Investment Management Inc.

Alpha Power Investing Newsletter Archives