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The 2023 January Effect Is Just A Piece Of The Broader Wintertime Rally In Small-Caps

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January 2023 has been a bumpy month for stocks, albeit a positive one based on the S&P 500’s nearly 4% year-to-date return and the small-cap Russell 2000’s nearly 7% gain over the same timeframe. These January gains, especially the Russell 2000’s outperformance, back up the long-running theory referred to as the January effect.

However, January 2023 could be just a small part of a longer wintertime rally, especially for small-cap stocks. Bloomberg data shows that the winter months average a return of 7%, versus the average summer-month return of 2%. Thus, there is clear precedent for what we’re seeing now — despite all the doom-and-gloom reports we’re seeing about the bear market and a potentially severe recession.

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What Is The January Effect?

For decades, many traders have relied on the claim that stocks, especially small-caps, tend to rise in January. However, multiple data shows that the January effect is hit and miss at best. For example, only about 57% of the Januarys over the last 30 years have been winning months for the S&P.

The Russell 2000 has fared a bit better, averaging a return of 1.4% for January since 1979. However, the win rate is a mere 55%, according to Bank of America data. Nonetheless, trends going into 2023 suggested the January effect could hold this year, and it certainly has, as evidenced by the solid index returns.

Now as January 2023 comes to a close, we're seeing the effects of the January effect start to fade. However, zooming out on the stock charts reveals that this month is just a small part of an uptrend that began in late September.

The small-cap Russell 2000 bottomed out around 1,655 in late September and has since climbed to 1,880 as of Jan. 25. The S&P 500 bottomed out around mid-October at about 3,583 before rising to about 4,001. Meanwhile, the tech-laden, mega-cap-dominated Nasdaq Composite continues to struggle, bottoming out at around 10,321 and laboring to reach 11,259.

This Winter Rally Still Favors Small-Caps

Although the January rally that lifted the stock indices appears to be dying, many smaller individual stocks are continuing the winter uptrend that started in late fall. In a report this week, Jefferies strategists advised investors to consider bumping their portfolio "down cap" by looking at the next rung down on the capitalization ladder.

They noted that even without strong inflows, several stocks at the bottom of the small-cap category have received big boosts. In fact, the smallest of the small-caps, those with a market capitalization below $500 million, are up 11.3% year to date.

The Jefferies team noted that many of the stocks in this group are the cheapest in the market, but they've been ignored until recently.

Small-Caps And Mid-Caps With Momentum

Jefferies continues to emphasize quality, although they admit that moving "down cap" while finding stocks with higher return on equity is a challenge. Nonetheless, the firm came up with several small-cap and mid-cap names that could outperform. In fact, a check of several of those stocks reveals ongoing positive momentum, even as the broader January effect appears to be ending.

 

In mid-caps, SVB Financial has gained 18% for the last five trading days, while Take-Two Interactive Software is up 8%. Firstcash Holdings has jumped 4% in the last five trading days, and Coty is up nearly 6% over the same timeframe.

Among small-caps, Navient is up 7% for the last five trading days, while Jackson Financial has popped 10%. Arch Resources has gained 13% over the last five trading days. Meanwhile, Urban Outfitters is up nearly 2% for the last five trading days, and Addus Homecare is up 3%.

A deeper dive is sure to uncover other mid-cap and small-cap gems with momentum.

Broader Trading Trends

Overall, Jefferies noted that cyclicals are quite cheap compared to growth. Secular growth is trading at around 45.3 times earnings and 3.4 times sales, compared to its averages of 23.6 times and 2.8 times. Jefferies expects the weaker dollar, China's reopening, and the possibility of a mild recession rather than a severe one to create tailwinds for cyclicals.

The firm also emphasized that companies with lots of overseas revenue should continue the improved performance that began in the fourth quarter. Although China's reopening has been bumpy thus far, Jefferies strategies expect global growth to pick up this year with assistance from the Asian giant.