The Weather Is Changing—Emerging Calendar Tailwinds for Small-Caps

2022 has been a notable year so far for small-caps, but for all the wrong reasons. Through this year’s first nine months, the Russell 2000 Index posted its second worst opening nine months to a year in its more than 40-year history. Of course, regardless of capitalization size, U.S. equity investors have been reminded of the relevance of the investment adage, “Don’t Fight the Fed” as the central bank’s hawkish pivot and rapid rate increases have led to the re-pricing of all financial assets.

Having established the scene in the rearview mirror, what do we think is ahead for small-caps? We have made the case previously that there are three counterintuitive indicators that have proven valuable for identifying attractive entry points for small-caps and that have been followed by above-average returns: low trailing returns, specifically five-year returns below 5%; moderate to high high-yield spreads, specifically 500 basis points or more; and elevated VIX readings of at least 20. All three are currently flashing green.

To this trio of signals, we would add two calendar-based patterns that lead us to expect that robust small-cap returns lie ahead. The first is the well-known and long-established pattern of seasonality, which we found is especially notable in even numbered years. We analyzed this pattern back to 1946 and found that, while the average small cap return for all six-month periods was 6.9%, the average from November through April was 12.0%. In even numbered years, this

What accounts for this longstanding, 75-year return pattern? The most widely held theory is that presidential and midterm elections held in even numbered years create uncertainty for small-cap stocks, which has had a negative effect on share prices, just as increased high-yield spreads and rising VIX levels historically have. This uncertainty may have contributed to below-average performance in the six months prior to the elections and above-average performance afterward, when greater clarity emerges on fiscal and regulatory policies.