Large vs Small Cap Seasonality
Lately I’ve had large vs small-cap index seasonality on the brain.
I’ve come to think that, like the bullish and bearish days that we highlight each month on the Monthly Seasonality Map, there are also strong and weak days for large caps relative to small caps.
I talked about monthly large vs small-cap seasonality earlier this month, but there are also daily seasonalities. A simple example is the first and last day of the month. As the graph below shows, large caps tend to be strong relative to small caps on the first day of the month and weak on the last.
[linearly-scaled, growth of $1]
Here I’ve assumed a simple pairs trade, long large caps (S&P 500) short small caps (Russell 2000), investing only on the first day of the month (green) or the last (red).
Geek notes: the two legs of the trade are not balanced 50/50% (because small caps are inherently more volatile than large caps). Allocation is based on volatility over the previous 21 days (more volatility = less allocation, and vice-versa). Trades are from close-to-close, and results are frictionless.
The graph shows that over the last 20+ years, large caps have opened the month strong (relatively speaking), while small caps have ended the month strong. The effect has waned since about 2000, but this example clearly illustrates that these large vs small cap biases exist.
Addendum to the Monthly Seasonality Map
To keep track of these new studies, I’ll be adding a second calendar to our Monthly Seasonality Map. I’ve included an example for December to the right (click to zoom).
High (low) numbers indicate large (small) cap strength. I’m still fleshing out my thoughts, so I won’t start tallying the real-time effectiveness of this new Map until January.
Unlike the existing seasonality map, this one would not be useful for straight long/short trades. When large caps go up, small caps will tend to go up more (and vice-versa) regardless of seasonality. That’s simply a result of volatility. This new map is instead focused on relative strength after adjusting for volatility.
In other words, it would only be useful for either (a) pairs-trading or (b) choosing between large or small caps once an investor already had an opinion about the short-term direction of the market as a whole.
I’ll be using the new Map for our new PWB Pairs Trading strategy to bias the direction of the pair (either long large/short small caps, or vice-versa).
Happy Trading,
ms
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