Small not always beautiful

I have some bad news for you if you are a big fan of small-cap stocks over large-caps:

Your seasonally favorable time is almost over. It lasts just until the end of this week, in fact.

That's because, from February through December, small cap stocks historically have performed no better than large caps.

This no doubt will come as a shock to those of you who in the past have confidently favored small-cap stocks because of their strong academic seal of approval. Many can point to the famous Ibbotson data, memorialized annually in their famous yearbooks, which consistently have shown that small-caps have enjoyed a strong margin of victory over large-caps, all the way back to 1926.

But there is one crucial feature of that data that has received far less attention: Virtually all of the small-caps' margin of victory is attributable to the month of January alone.

To document this, I turned to the monthly data on the performance of small- and large-caps calculated by Eugene Fama and Kenneth French, finance professors at the University of Chicago and Dartmouth, respectively. Their dataset shows that, cumulatively since 1926 for all non-January months, the 50% of stocks with the smallest market caps have slightly underperformed the 50% of stocks with the largest market caps.

What this means: If you're a small-cap investor, the historical odds are almost exclusively concentrated during the month of January alone. While the small-cap stocks that you own might still outperform the market during the other 11 months of the year, it won't be because of any historical precedents in their favor.

While one could equally draw this lesson of history in any year, it is especially important to draw it now, given how overvalued small-cap stocks in general appear to be, relative to large-cap stocks.

I owe this insight to Jeremy Grantham, the chief investment strategist at GMO. For several months he has been arguing that, in the wake of the extraordinary performance of the smallest-cap stocks since last March's market lows, it is far safer now to bet on the large-caps.

The bottom line? You should invest in a small-cap stock only because you believe it is fundamentally a sound investment. Your rationale for investing in it should not be that it is a small-cap.