The January Effect is one of the more predictable occurrences in the equity market—provided the right circumstances.  All it takes is an otherwise crummy year with investors running out of reasons to sell.

As the calendar year-end approaches, markets tend to come under selling pressure due to tax-loss selling.  When the markets re-open in the new year, that selling pressure is gone and investors are once more free to invest with an eye toward growth.

And when the market decides its “risk-on” time, small cap stocks will shine.

“I think it’s reasonable to say we saw a lot of tax-loss selling at the end of 2011,” says Jennifer Law, vice-president of CIBC Asset Management, and portfolio manager of the Renaissance Canadian Small-Cap Fund. “If you look at January, the performance of small caps showed some of the January Effect—small caps outperformed large caps by about 380 basis points.

“We’re not surprised that they outperformed, we just weren’t sure the extent of it—380 basis points in one month is spectacular.”

She says when investors “don’t love” small caps, they get out at any cost, resulting in significant multiple contraction.  When she saw the valuation compression small caps were undergoing at the end of 2011, she knew they would bounce back in the new year.

“When people don’t love equities, small caps underperform,” she explains. “If the market likes equities, small cap tends to outperform—it’s the higher beta side of equities.”

While investors were spooked in the third quarter, they were largely coming to terms with sovereign risk headlines by the end of 2011.  Improving economic data also fueled optimism toward North American growth. The combination of less fear and better news means it’s now a risk-on market.

“We should see better performance out of small caps,” she says. “The February effect is pretty good too, so far.”

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