Why it may be time to sell small caps

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In early December we noted that small cap indices and related exchange traded funds have a history of outperforming U.S. equity indices from the middle of December to at least the end of February. Thackray's 2012 Investor's Guide notes that the Russell 2000 index has outperformed major U.S. equity indices from Dec. 19th to March 7th. The Russell 2000 Index has gained in 25 of the past 32 periods for an average gain of 5.5 per cent. Since December 12th, owning an exchange traded fund in the Russell 2000 index has been profitable once again, but has gained only 1.7 per cent. What is the preferred strategy now?

An entry point for the seasonal trade near mid-December is related to a series of annual recurring events. Frequently, the recovery starts during the traditional Santa Claus rally period from Dec. 15th to Jan. 6th. Tax-loss selling pressures for individual investors are relieved. In addition, institutional investors start to look for equities with higher risk and greater potential return that are purchase candidates in the New Year. Frequently, top selections are found in the small cap sector.

On the charts, the seasonal trade started well, but is not ending well. The Russell 2000 index outperformed the S&P 500 index and Dow Jones industrial average from mid-December until mid-February. The index advanced from 745 to 830, a gain of more than 11 per cent. However, its period of seasonal strength ended earlier than usual this year. The index became overbought, its short-term momentum indicators began to roll over and strength relative to the S&P 500 index began to deteriorate. On Friday, the Index broke below short-term support at 811 to close at 802.42 and established a short-term downtrend. It's not too late to liquidate holdings related to the seasonal trade near current prices.

Exchange traded funds in the sector include iShares Russell 2000 Index , iShares Russell 2000 Index U.S. Dollar hedged , iShares Small Cap 600 Index , Vanguard Small Cap ETF and iShares Canadian Small Cap ETF . In addition, an inverse ETF is available, the Short Russell 2000 ETF .

Don Vialoux is the author of free daily reports on equity markets, sectors, commodities and Exchange Traded Funds. . Daily reports are available at www.timingthemarket.ca/. He is also a research analyst for Horizons Investment Management Inc. All of the views expressed herein are his personal views although they may be reflected in positions or transactions in the various client portfolios managed by Horizons Investment Management.