Large companies (large caps) have been outperforming in the stock market recently, but that might all change very shortly. Small companies (small caps) have on average outperformed from December 19th to March 7th. From 1979/80 to 2008/09, the Russell 2000, the venerable index of small companies in the stock market, has produced a return of 5.4% during its seasonally strong period. This compares with a return of 2.1% for the Russell 1000 (large cap index) during the same time period.

The Small Cap Effect is a modified January Effect strategy, which is one of the most researched seasonal anomalies in the stock market. This traditional strategy is based upon small companies outperforming in the month of January because of tax loss selling in December.

The premise of this strategy is that investors sell their small caps in December to generate losses in order to offset any capital gains that they created during the year. Investors are more likely to sell their small companies that are trading at a loss, rather than their large companies
because they typically see their large companies as longterm holdings. The net result is small company stocks are often beaten down in price and end up representing good value for an astute investor.

This strategy has worked well, but the entry date has shifted from December 31st to December 19th. The shift has been caused by the popularity of the strategy. As more and more investors have tried to capitalize on this strategy, the date has shifted. Seasonal investors take advantage of the “earlier” January Effect by getting into the sector before the other investors who are still operating under the old paradigm of the trade starting at the beginning of January.

In the next few days, I will write the highlights of approaching seasonal opportunities for investors.

Canadian financial stocks typically start their outperformance towards the end of October. Canadian banks have a year end of October 31st and they have often announced dividend increases at this time and forecasted positive results for the next year. In anticipation of positive announcements at the end of November, investors tend to increase their holdings in November.

So far this year, after positive announcements by most of the large banks, the sector has performed in a lackadaisical fashion. Despite the sector being in its period of seasonal strength it is not expected to dramatically outperform the market. As a result, it is not substantially overweighted in the HAC portfolio.

There maybe a pickup for Canadian banks after the American banks “prove” themselves. This is what took place last year. As it is the American financial sector that lead the market into its steep decline, investors will be looking for signs of change mid-January during the release of bank’s earnings. It is possible that the sector might pickup early if there is a expectation of strong earnings. Nevertheless, investors, like last year, will be hesitant to take a large position in Canadian banks until the sentiment for American banks becomes more positive.

The consumer discretionary sector has been performing as expected as it is outperforming the consumer staples sector. During the favourable six months from the end of October to the beginning of May the discretionary sector is the preferred sector. This year the consumer discretionary sector has been outperforming the consumer staples sector, as expected.

The agriculture sector, represented in the fund by the holding MOO, Market Vectors – Agribusiness ETF, has performed extremely well. On a seasonal basis the agriculture sector usually outperforms from August to December. This year the sector has performed particularly well as grains have benefited from the falling U.S. dollar, fertilizer stocks have benefited from farmers no longer on the brink of bankruptcy needing to apply fertilizer and increasing farm equipment sales.

From a technical perspective the sector has had a breakout and is expected to continue to do well. From a seasonal perspective the sector finishes its period of strength at the end of the month and investors should consider reducing or exiting their positions.

Technology stocks have been doing well in accordance with their seasonal trends. Both the XLK, Technology Select Sector SPDR Fund, and SMH, Semiconductor HOLDRs Trust, holdings have been outperforming the market recently. The seasonal sector trade for these sectors ends on January 17th, but it is usually prudent to start lightening up on the sector before the Consumer Electronics Show in Las Vegas which takes place in the first week in January 2010.

The HAC fund has been well positioned in the market place to take advantage of outperforming trends in the market. The materials sector in the Canadian market has been performing well. One of the main sector holdings for HAC is XMA, iShares CDN S&P/TSX Capped Materials Index Fund. This ETF has benefi ted from strong performance in gold, fertilizer and metals and mining stocks. Approximately 60% of the fund is gold stocks, 18% fertilizer stocks and a sizeable portion of metals and mining stocks. Recently, all three of these sectors have been outperforming the market – gold has been rising and has crossed the $1,200 threshold, fertilizer stocks have done well as demand has increased for fertilizer, and the metals and mining stocks have been doing well in part as a result of the declining U.S. dollar.

Gold has its strongest seasonal strength from July 12th to October 9th. At that point it often corrects and then at the beginning of November it once again starts to rise. This year gold did not produce a gain from October 9th to October 30th. At the beginning of November once again started to increase. Gold very often will increase until approximately the end of the year, or even into February with strong momentum.

Based upon the seasonal trends it is prudent to consider lightening up on gold positions over the short to midterm. The same rational applies to XMA as it is mainly gold stocks.