With so much media and investor attention focused on the upcoming U.S. election, it's worth pointing out that history suggests political events may not be the most important ones for small-cap investors this week. November begins what could be called "Small-Cap Season." There is a robust historical pattern, which seems only partially understood, of small caps posting much higher returns on average for the six months beginning November 1 than for other comparable periods throughout the year.
We went back 75 years to September 1945 and calculated the returns for every November to May period (specifically October 31 to April 30) compared with the average of all six-month periods. We used the CRSP (Center for Research into Security Prices) 6-10 Index as our small-cap proxy. The return difference is striking:
The Big Difference in Returns During Small Cap Season
CRSP 6-10 Rolling Average Six-Month Returns from 9/30/45 through 9/30/20
1Period calculated from 10/31-4/30.
For all six-month periods, small caps averaged 6.9%, but the November to May periods averaged a gain of 12.0%. This is particularly compelling in that the rolling monthly one-year average return for the CRSP 6-10 was 14.0% from 1945 through 9/30/20.
We should caution that these results are the average of multiple periods. There are exceptions, such as the most recent period: From 10/31/19-4/30/20, small-caps, as measured by the CRSP 6-10 Index, dropped 11.8%.
Small-cap returns during their "season" were not only strong versus their own history, but small-caps have also historically outraced large-caps by a great extent during these historical six-month stretches. If we look at all of the six-month periods since 1945, we find that small-caps beat large-caps by an average spread of 1.0%, yet in only 48% of all six-month periods. In contrast, during the November to May periods, small-caps beat large-caps 55% of the time by an average spread of 3.4%.
Small Caps Beat Large Caps by a Wider Spread During Their Season
CRSP 6-10 vs CRSP 1-5 Rolling Average Six-Month Returns from 9/30/45 through 9/30/20
1Period calculated from 10/31-4/30.
There are several hypotheses about what leads to this seasonality. One popular theory revolves around tax deadlines. U.S. registered mutual funds must take losses by October 31 in order to count towards their distributions in that calendar year. Similarly, U.S. investors need to take tax losses by December 31 to count those losses on that year's taxes. The theory posits that these two tax-based deadlines encourage fourth quarter tax related selling, which puts downward pressure on small-cap stocks. When this selling pressure abates, small caps recover more strongly. While this theory is plausible, one wonders why this tax selling effect is so much greater for small caps. If large-cap investors sold their losing positions, that should also drive down prices. Further, would selling pressure focused on the losing stocks pull the overall small-cap index, which contains 1,881 stocks, down enough to see this kind of effect? Perhaps, but there may be another factor involved, one rooted in behavior.
Brokerage analysts consistently overestimate companies' next year earnings. Our friends at Furey Research have estimated that perennially optimistic small-cap analysts set earning growth expectations that are, on average, about 30% higher than realized. Hope seems to spring eternal each year. By this reckoning, small-cap investors get caught up in this optimism as they look towards next year. This sunny view does not begin to dissipate until first quarter earnings are reported, often from late April to early May, when they sometimes reveal inconvenient facts that prompt a reassessment.
It seems fair to say that the explanation for this seasonal pattern is not fully understood. Still, the scale of the higher returns during the small-cap season over the past 75 years seems worth paying attention to.
As advocates of long-term investing in small caps, we are not suggesting that investors buy now for just the next six months. Quite the contrary—we see the upcoming economic recovery as supportive for small-cap returns for multiple years. Having said that, if investors haven't yet made their small-cap investments, the beginning of small-cap season would seem to be a great time to start.
Mr. Lipper's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
