Two Words About ‘January Effect’: Forget It, Forget It, Forget It . . .

Hope springs eternal at the start of each year for small-company stock fund investors.

No wonder. In 60 of the last 73 Januaries, small-cap stocks (commonly defined as companies with market capitalizations of $1 billion or less) have outperformed large blue chips.

The reasons for this aren’t entirely clear. But so common is this phenomenon that it has its own name: “the January effect.”

Frustrated by five consecutive years of disappointing returns in this sector, small-cap investors may be tempted this month to load up on these shares--which are considered to be woefully undervalued relative to large-company stocks--in an effort to “time” the market and reverse their fortunes.

This is a loser’s bet.

For starters, the January effect doesn’t even take place in January anymore. Small caps haven’t really outperformed large caps in January since 1993.

“As soon as people become aware of a phenomenon, it’s bound to disappear,” said John Rekenthaler, director of research for Chicago-based fund tracker Morningstar Inc. Or it gets pushed back.

“Obviously, if everyone knows about the January effect, they buy at the end of December to take advantage of it,” Rekenthaler said. “That pushes it up into December.” Then, investors wanting to take advantage of “the December effect” will start buying in November. And so on and so forth.

This time around, the January effect may have taken place as early as October.

Take a look at the Russell 2,000 index of small-company stocks. It finished behind the benchmark Standard & Poor’s 500 index of blue-chip stocks in the fourth quarter. But lop off the first week of the quarter, when small caps plummeted nearly 15%, and small companies handily beat the S&P.; From Oct. 8 to Dec. 31, small caps soared 36.4%, versus 28.5% for the blue chips.

If this rally had occurred in any other quarter of the year, you would all know this by now. Unfortunately, it took place in the fourth quarter, when attention was focused on the year end. And for the year, small caps, despite their fourth-quarter meteoric rise, still lost money.

“There’s been just a huge rotation in market leadership,” said Louis Navellier, manager of the Navellier Aggressive Small-Cap Equity fund. “But nobody knows about it yet.”

That isn’t the only problem: The small-cap rally may already be over.

In the first trading week of the new year, large caps have retaken market leadership, with the Dow Jones industrials up 5%, versus 2.2% for the Russell 2,000.

No one is saying--or could say with certainty--that small caps won’t have a good year. They could. They’re certainly due for one.

But even true believers in small-cap stocks fear that large caps may do even better.

Notes Prudential Securities small-caps guru Claudia Mott: “I’m not as positive as I once was” that small caps will outperform the blue chips. She cites uncertainty in small-company earnings.

Adds Thomas McDowell, partner at Rice Hall James in San Diego and co-manager of the UAM Rice Hall James Small Cap Portfolio: “We could be seeing the tail end of the rally.” He cites supply and demand--there are too many dollars trying to chase too few blue-chip stocks, leaving small-company shares behind.

Obviously, the experts could be wrong.

OK. For the sake of argument, let’s assume that small caps bolt past larger stocks in January.

Is there really any harm in having only, say, 5% to 10% of your portfolio in small stocks, as Edward Jones chief investment strategist Alan Skrainka suggests?

Conventional wisdom says investors need to have a sizable portion of their holdings in small-company stocks, because over the long haul small caps grow your money faster than large caps do.

The evidence often cited is a well-known study by the Chicago-based research firm Ibbotson Associates, which found that in the 70-year period starting in 1926, small-cap stocks have produced annualized returns of 12.5%, versus 10.5% for large-cap stocks.

But let’s examine these numbers.

Take away just three years in that 70-year period--1933, when small caps rose 142.4%; 1943, when small caps gained 88.4%; and 1967, when they were up 83.6%--and large caps would have outperformed, Skrainka found.

“The merits of small caps have definitely been overstated,” said Morningstar’s Rekenthaler. “They haven’t really justified their existence since 1983.”

Here’s something else to consider. “When small caps do well, large caps do well too. Just not as well,” said Dan Coker, emerging-growth strategist for Schroder & Co. in New York. (Indeed, in only six of the top 100 months for small-cap stocks, dating back to 1926, have large caps actually lost money, according to Ibbotson Associates.)

This means that small caps really don’t offer investors much “downside protection” as part of a diversification strategy. Rather, they offer the “upside potential” of delivering slightly higher returns.

And they offer downside risk. Because sometimes when large caps do well, small caps flat-out don’t. (If you need convincing, look at what happened in 1998.)

That’s why Bohemia, N.Y., financial planner Ron Roge says a “market weighting” in small caps--that is, 15% to 20% of one’s stock portfolio--is plenty.

Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.