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Stocks are typically grouped into three or four categories based on their market valuation or capitalization, i.e. “market cap:” Market cap is calculated simply by multiplying the current price of the stock by the number of shares of stock that have been issued by the underlying company. There is no official definition or dollar value level for the four major market cap categories. They vary over the years and from entity to entity. But generally, large cap stocks have market valuation of $5 billion or more, mid caps are between $1 billion and $5 billion, small caps are under $1 billion, and micro caps are under $100. For example, if company XYZ’s stock trades at $20 per share and it has issued 25 million shares, it has a market cap of $625 million and would be considered a small cap stock.

It is has been reported that the “January Effect” was first identified by economist and investment banker Sidney Wachtel. Mr. Wachtel studied the seasonal movements in the stock market and is believed to have coined the term “January Effect.” He detailed his research in his 1942 paper, “Certain Observations on Seasonal Movements in Stock Prices,” which appeared in the Journal of Business published by the University of Chicago Press. The theory and pattern was that U.S. stock prices outperformed in January and that small caps outperformed large caps in January. The January Effect phenomenon was likely caused by yearend tax loss selling of small cap stocks, driving their stock prices down. These bargain stocks are often bought back in January with the help of yearend bonus payments in January.

Over the years we reported annually on the fascinating January Effect showing that Standard & Poor’s Low-Priced Stock Index during January handily outperformed the S&P 500® Index 40 out of 43 years between 1953 and 1995. Small caps on average quadrupled the returns of large caps in this period. Then, the January Effect disappeared over the next four years. S&P decided to discontinue their Low-priced index, so needed a substitute. With the advent of the Russell Indices in 1984, a consistent, convenient benchmark was created, the Russell 2000® index of small cap stocks. This index consists of the 2000 companies with the smallest market caps within the Russell universe of the 3000 largest U.S. firms. This index is our preferred small-cap benchmark used in the Stock Trader’s Almanac .

Small Caps Begin to Blossom in Late October

The tendency of small-cap stocks to outperform big caps, known as the “January Effect,” is clearly revealed in Figure 1. Thirty-four years of daily data for the Russell 2000 index of smaller companies are divided by the Russell 1000® index of largest companies, and then compressed into a single year to show an idealized yearly pattern. When the line on the chart is descending, large caps are outperforming small caps; when the line on the chart is rising, small cap are moving up faster than large caps.

In a typical year the small cap stocks stay on the sidelines while the large caps are on the field. Then, around late October, small stocks begin to wake up and in mid-December, they take off. Anticipated year-end dividends, payouts and bonuses could be a factor. Other major moves are quite evident just before Labor Day—possibly because individual investors are back from vacations—and off the low points in late October and November. Small caps hold the lead through the beginning of May.

FIGURE 1 Russell 2000/1000 One-Year Seasonal Pattern Chart

Russell 2000/Russell 1000 one year seasonal pattern