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