1994 was a tough year for small-cap stock managers, and judging from January's lackluster performance, 1995 doesn't look much better.
The so-called January effect - outperformance of small-capitalization stocks over larger-cap stocks in January - occurs because small stocks rebound as money pours back into the market following year-end, tax-related selling. This is the second consecutive year in which small stocks underperformed large stocks in January.
Excluding 1995, there have been only 12 times since 1926 when the January effect has not occurred, according to the University of Chicago's Center for Research in Securities Prices.
Why is this important? Because in nine of the 12 cases, the small-cap sector underperformed the large-cap market for the entire year.
"Most of the time when small stocks underperform in January, they underperform for the year. That implies that they will again underperform in 1995 even though valuations are reasonable," said Robert Natale, director of equity research of Standard & Poor's Corp., New York.
The Russell 2000 index, a popular barometer of small-cap stocks, lost 1.4% in price during January. The Standard & Poor's 500 Stock Index, which tracks large-cap stocks returned 2.59% on a total return basis. In January 1994, the Russell index was up 2.6% on a price basis while the total return of the S&P was 3.4%.
1994's calendar-year results followed suit. The Russell was down 3.2% for the full year while the S&P returned 1.3%.
The effect is similar when one looks at data from Ibbotson Associates, Chicago, on what most portfolio managers would consider "micro-cap" stocks. Since 1926, the Ibbotson data show only 10 years in which small stocks underperformed large ones in January. In six of those 10 instances, small-cap stocks did not outperform large caps for the year.
Despite the grim lesson of history, small-cap managers remain surprisingly bullish. Some even argue the so-called January effect occurred in December 1994 instead, given the small stock rally during the last two weeks of the month. In the last 10 years, with the growing influence of mutual funds - which typically end their fiscal years on Oct. 31 - small caps have seen their performance surge in November and December, some experts say.
Jenny Beth Jones, senior vice president of Oppenheimer Capital, New York, and portfolio manager of the Quest for Value Small Cap Value fund and separate accounts, said: "While the January effect may have been valid several years ago, it's not as valid today, if at all."
"A lot of the tax-loss selling, which creates a downtick in small stocks, is not really done at year end. Many mutual fund years end in October. Because of the phenomenon of how much mutual funds have become surrogates for small investors, one would expect a November effect, which hasn't really occurred. The (rule about the) tax law is not really valid today," Ms. Jones said.
Others don't buy that theory.
"There's lot of window dressing for mutual funds in November and December. But the January effect is supposed to take place in January," Mr. Natale of S&P said.
Small stocks "have done nothing but lag since the first of the year. The end of the year (outperformance) needs to carry over into the first of the year for there to be a 'January effect,'*" said Claudia Mott, director of small-cap research of Prudential Securities, New York.
"What happens if small caps don't beat large caps in January? They don't outperform for the year. The same thing happened last year," Ms. Mott said.
Were the last two years just interruptions in a longer cycle of outperformance?
"That's just not how the cycle tends to work. I know I'm a lonely voice. You can all pray I'm wrong," Ms. Mott said. "I said in December if the small sector doesn't win in 1994 then it probably means the cycle is over."
Many portfolio managers disagree.
In 1994, the overall stock market was spooked by worries about the economy; the Federal Reserve Board's interest rate increases; the Orange County, Calif., bankruptcy and Mexico's currency devaluation, said Mary Lisanti, managing director of Bankers Trust Co., which runs $900 million in small- and midcap stocks.
And small-cap investors in particular were nervous because the sector underperformed large caps last year. "Small caps - when there's a high amount of uncertainty - don't do well," Ms. Lisanti said.
What's more, she said there was less tax-loss selling in December than usual as investors decided to wait for Congress to consider a capital gains tax cut, which would benefit non-dividend paying stocks, including the majority of small caps.
"If this next round of tightening is the last round or close to it, then the second half could be good for small caps. I still think we're in an up cycle," she contends. What's more, the Mexico fallout might divert investors from that market to U.S. small-cap stocks.
"Small caps march to their own drummer and are less sensitive to the overall economy (than large companies)," Ms. Lisanti said. For instance, they rallied in 1980 to 1982 when interest rates were up and the economy was in and out of a recession, Ms. Lisanti said.
Dean McQuiddy, vice president and senior portfolio manager at Barnett Banks Trust Co. N.A., which runs the $58 million Emerald Small Cap mutual fund, said: "We think we're halfway through a small-cap outperformance cycle. ... The Fed's interest rate hike made the full year of 1994 difficult. It broke a string of three years where small caps did better than large. It was a correction in a long-term bull market for small stocks."
In terms of cycles of outperformance, dating to 1925, "there has been no other instance in which an up cycle was only three years," said S&P's Mr. Natale.
Mr. McQuiddy added that small stocks are selling at reasonable valuations, with earnings at a 30% premium to those of S&P 500 companies. If this were the end of a small-cap cycle, "the relative p/e ratio could be two times the market's level."
Al Santa Luca, senior vice president of Capstone Asset Management, Houston, which runs $140 million in small-cap stocks, said: "1994 was an odd year in the sense that small caps peaked in March, really sold off hard into June, bounced dramatically in October and November, then stabilized."
"There were big divergences among sectors. That effect will be magnified in 1995. You need to be a little more sector-oriented than in 1991 and 1992 when the whole small-cap market did well," said Mr. Santa Luca. He intends to focus on service sectors with such stocks as Flserv Inc., a transaction processing company, and Ecolab Inc., a cleaning service for fast food chains and hotels.
Mr. Santa Luca thinks "technology will be the big negative surprise for 1995 because it did so well in 1994, especially given higher interest rates."
Michael Magiera, managing director of the fund group at Rochester, N.Y.-based Manning & Napier - whose $105 million small-cap fund managed to chalk up a return of 8.01% in 1994 - said: "Last year was a good year. 1995 is lining up to be similar. It will be a good stock-picking environment, not a good indexing environment." Among his favorites: International Imaging Materials, which makes thermal transfer ribbons for color printers, and Edmark Corp., a software company.