Time to Sell the Small Caps?

Back in December 5 2009 I authored an item in the Toronto Star entitled the January Effect. Now according to seasonality bible, The Stock Trader's Almanac, the January Effect is the period from mid-December through the following January when smaller companies may outperform larger companies. A weak January Effect is a bad omen, and could be a negative for the next 12 months because smaller companies tend to be more sensitive to the domestic economy, while larger companies or multi-nationals tend to be more sensitive to the global economy.

We are assuming that for the most part, the smaller companies will lead the way down into a local bear market and lead the way up on a local bull market

In the U.S. market our proxy for the smaller companies will be the Russell 2000 index and for larger companies, either the Dow industrials or the Russell 1000 index. In Canada, our proxy for smaller companies is the S&P/TSX Small Cap Index and for larger companies, the S&P/TSX60 (XIU) Index.

The problem here is the S&P/TSX Small Cap Index or the related iShares CDN S&P/TSX SmallCap Index Fund (XCS-T) unlike the Russell 2000, is in no way a proxy for our domestic economy. Our Canadian small cap sector is basically a basket of 183 tiny companies most of which are in the Materials and Energy sectors. The CDN Small Caps are strictly a measurement of risk. When appetite for risk improves the CDN Small Caps out perform the larger companies and when risk appetite subsides – the CDN Small Caps under perform the larger companies

Our chart is the weekly XCS over the XIU where the XCS traces out a bullish set up (positive divergence) relative to the XIU in March 2009. The confirmed “buy” of movement to risky assets occurred on April 24, 2009 when the XCS broke above the January 9, 2009 recognition point. Now there is danger as the XCS completes a wave (3) advance and is setting up a possible wave (4) swing failure. Clearly this appears to be the early stages in the movement of capital away from risky assets

The Currency Hedging Myth

They say the definition of insanity is when you do the same thing over and over expecting a different result. Do you ever wonder why the financial media keeps asking industry experts to recommend a “solid diversified” equity portfolio using exchange traded funds (ETFs) and expecting some kind of new concept or breakthrough analysis?

The recommendations are usually to own some Canada along with mix of “currency hedged” global exposure such as U.S., Europe, Asia Pacific, Emerging Markets & Japan ETFs and maybe some speciality theme like AGRA or Green Energy. The idea is to own a basket of assets that have some degree of non-correlation but the problem is – thanks to Globalization – all of the global bourses have a high degree of correlation. In other words all of the global markets rise and fall at the same time admittedly with some difference in magnitude.

Today the only way we can achieve any degree of diversification is by global currency exposure. That means we should avoid currency hedged investment products. You see if we diversify by country or region and wrap it all in currency hedges – we may as well just own one security – our own S&P/TSX60 Index. One example of an “avoid” product would be the iShares CDN S&P 500 (XSP) Hedged to Canadian Dollars Index Fund seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P 500 Hedged to Canadian Dollars Index. This product was introduced in May 2001 and adopted the dollar hedge in November 2005 in reaction to the 2003-2005 run up in the Canadian dollar. Remember in order to increase market share the manufacturers of ETF products have to create sexy add-ons such as currency hedging and managed products in order to “excite” retail investors.

Back to investing reality - our CDN dollar model displays two material hedging problems. The CDN dollar hedge is a wash since mid 2007 (it actually backfired in 2008) and our CDN $ model is about to generate a “sell” signal. Also something to keep in mind if your over-weight in commodities

TSX Energy; Seasonality vs. Proper Analysis

A few weeks ago I examined a seasonality clip from DVTechtalk January 18, 2010 – promoting Thackray’s 2010 Investor’s Guide and highlighting Seasonality in the Energy Sector. According to Thackray’s 2010 Investor’s Guide, seasonal influence on the U.S. Energy sector is from February 25th to May 9th. Brooke also has completed other studies in the sector and has found that seasonality in the Canadian energy sector, U.S. Oil Services sector and the U.S. Oil Exploration and Production sub-sector are slightly different. Their period of seasonal strength is from January 30th to May 9th.

I back tested the seasonal trades and discovered the seasonal Energy calls simply never worked over the last 10-years. A simple buy-and hold from January 2000 to date returned 315% and the seasonal trades generated 179% over the same period. The worst period was during the great 2000-2006 advance when the seasonal trades had us sell high and buy back even higher.

I also found that when traditional and legitimate technical studies are used, better performance is achieved with much lower trading activity and the associated costs. Now “traditional and legitimate technical studies” can be long term moving averages, primary trend lines or simple weekly or monthly momentum studies. In the study pictured I used simple relative averages (RA) or the relative performance of the TSX Energy vs. the large cap S&P/TSX60 Index – monthly data. I have also laid on a True Range Price Channel to illustrate a supporting study using totally different math. In each case we were out during the bumpy 1998 – 2000 window and were long through the great 2001-2007 advance during which the seasonal strategy generated 12 in and out trades.

At this time our simple RA model has us long on July 31, 2009 following a sell on October 31,2007. Most notably is the low trading activity with only 5-trades over 11-years. The last sell is to be ignored because we only have a partial February bar.

U.S. Materials seasonality, fact or Folklore?

I do not follow seasonality because from past experience I find in a bull market seasonality will have you buy - sell higher - and buy back even higher. In a bear market seasonality will have you sell - buy lower - and sell even lower.

I clipped this from DVTechtalk Monday February 1, 2010 – Thackray’s 2010 Investor’s Guide notes that the U.S. Materials sector has a period of seasonal strength from January 29th to May 6th. The trade has been profitable in 16 of the past 20 periods. Average return per period was 8.0%. The sector outperformed the S&P 500 Index by 4.5% per period.

This is my fourth seasonal trade audit having looked at platinum, TSX Energy, U.S. Financials and now the U.S. Materials sector and one theme emerges. Seasonal trades do not work in bull markets. During the great January 1999 to April 2008 bull in the U.S. Materials Sector, a buy-and-hold returned +91% and 20 seasonal trades returned +60%. The only big call during the entire period was the sell at month-end April 2008 but once again one could also argue that in April - May 2008 you could have sold anything and been correct. Also as of now the seasonal model has missed the May 2009 to January 2010 17% recovery having sold last April month-end.

At the moment the fact-or-folklore question suggests a seasonal trading strategy fails in bull markets but I need to study the results of seasonal trading in protracted bear markets. At this time I have to conclude that seasonal strategies such as those served up by Thackray and the classic Stock Trader’s Almanac may invite curiosity from retail investors but are not suitable in the real world of money management