November Could Be a Big Month for Small Caps

Although history is in smaller stocks' favor, some market watchers expect the headwinds that have daunted small companies this year to continue through the fourth quarter, and potentially dampen their usual year-end rally.

The small-cap benchmark Russell 2000 index was essentially flat in October, and December has become a less reliable month for gains. Still, there have been only eight years since 1979 that small caps failed to rally in the fourth quarter, according to research by Citigroup's small-cap and midcap equity strategist Lori Calvasina.

So far this year, the Russell 2000 is off 2% through Friday, lagging the Dow Jones Industrial Average, which is up 5%, and the S&P 500, which is up 3%. In October, the Russell 2000 gained a nominal 0.4%.

"The markets have rallied in the fourth quarter since 2001, so money managers are expecting it," says Jim Bell, who co-manages the Old Mutual Small Cap fund (OBSWX). "I think this year might be a little different, with volatility much higher. I wouldn't expect as large of a rally for small caps in this fourth quarter as we've seen in years past."

Small-cap stocks usually benefit from what some on Wall Street call the "November effect." Mutual funds sell losing positions before their fiscal years end on Oct. 31 to offset capital gains and therefore reduce capital-gains tax liabilities. Then, funds buy back stocks in November ahead of an expected New Year's rebound. Smaller stocks get an extra lift because they have smaller public floats, so a few trades easily bump up their prices.

Last year, the Russell 2000 gained 9% in the fourth quarter, reversing a 5% decline from the prior two quarters, according to Calvasina.

November and December have historically been reliable for gains. The Russell 2000 has increased in 68% of Novembers and 79% of Decembers since 1979, according to Calvasina.

But over the past six years, December hasn't been as good of a month for small caps. The Russell 2000 was flat last December, fell 1% in December 2005 and lost 6% in December 2002. But the small-cap benchmark has gained in every November since 2001. The reason? More investors are likely piling into the season earlier to get in first, making November the month to watch.

Mike Morris, a portfolio manager of the Delaware Small Cap Core fund (DCCAX), says there are countervailing forces at work for small-cap stocks heading into the fourth quarter. "From an earnings perspective, small caps as a whole are probably disadvantaged vis-a-vis large caps, which are more internationally exposed and relatively shielded from domestic slowdown," Morris says. On the other hand, "an accommodative Fed could balance some of the earnings pressure."

Some factors that tend to foretell underperformance for small caps: rising volatility, widening high-yield credit spreads, rising consumer loan delinquencies and slowing corporate earnings, according to Citigroup's Calvasina. Each of these is already in play and clamping down investors' risk appetite, putting smaller companies at a disadvantage vs. larger, more-established names, she says.

"Given looming concerns about whether the U.S. economy is headed for recession, we would not be surprised to see investors move to the sidelines in December...which could cut short any fourth-quarter rally in small caps," Calvasina said in a research note on Oct. 25.

If you prefer not to buy the iShares Russell 2000 (IWM) exchange-traded fund outright, then Calvasina has found one company under $1 billion in market cap that has risen in each November-December period since 2001. Casella Waste Systems (CWST), of Rutland, Vt., provides trash collection and recycling services in the eastern U.S. Last year, the company rose nearly 8% between November and the end of December, although it isn't clear what drove the gains.

"The trends that have been present all year will generally continue to be present in the fourth quarter," says Jeffery James, who manages the small-cap growth strategy at Driehaus Capital Management. "The fourth quarter is generally a positive quarter for small caps, but there are a lot of crosscurrents adding to volatility — concerns about the dollar, the ripple effect on inflation and oil. So I expect equities to continue to be choppy."

Still, James is bullish on several sectors heading into the end of the year including solar energy, aerospace, oil-related companies and companies focused on exports.

Ultimately, earnings should be the key driver. On the bright side, 68% of companies on the Russell 2000 have surprised Wall Street with better-than-expected earnings in the past year, according to Russell Investments. At the same time, earnings for companies on the small-cap benchmark are down 3% compared to last year as of the third quarter.

James McIlree, director of research and a senior analyst at Collins Stewart, who follows several small-cap defense and diversified technology companies, notes that the share prices of small companies he follows look reasonable so they should rise if earnings are positive this quarter. When stock prices are overextended, stocks can stumble despite healthy profits.

"I'm not overly worried about Q4," McIlree says. "I'm really thinking about what's after '08 and what the tea leaves are saying I should start thinking about for '09."