On average, says the Stock Trader’s Almanac for 2009, buying stocks trading at 52-week lows in the week before Christmas and holding them for a 4- to 6-week period has generated average gains of 13% since 1974, versus 3.4% in the market. This “Free Lunch” strategy performs best, says the Almanac, after market corrections and when there are a lot of new lows. That would seem to fit the description for 2008.

In the interests of disclosure, I should mention that I purchased a small-cap exchange-traded fund in November (iShares CDN Small Cap Index Fund). It’s intended as a long-term investment, but a nice uptick in January would help improve the morale.

By the way, for anyone still contemplating tax-loss selling, there is some academic research that suggests it may be better to do it in January, believe it or not. Apparently, you would be further ahead because the price gain from the January effect would on average offset the lower tax-loss claim.

And once in, you might consider staying. Studies by leading academics such as Kenneth French and Eugene Fama find that small caps average 12% annually over the long run.

The current downturn for small caps is the worse of the past seven says Sartz. Small cap indexes are down by over half. Past declines were 28% to 43% from market peaks. The spring back after the 2008 bear could be exciting. 

We are in the midst of tax-loss selling season too and a lot of small caps are down for that reason. If past tendencies emerge, January could see good snap back.

So small-cap exchange-traded funds (ETFs) look like good places to deploy funds if you are one of the brave now looking to buy low and sell high. In Canada, there is the iShares CDN SmallCap Index Fund. In the U.S., there is:

• iShares Russell 2000 Index
• iShares Russell Microcap Index
• SPA Market Grader Small-Cap 100
• First Trust Small Cap Core AlphaDEX
• PowerShares Dynamic Small Cap
• RevenueShares Small Cap

For example, the growth of mutual funds and pension funds over the 1980s and 1990 is credited with reversing the premium observed on small caps over large caps in previous decades. How so? As investment decisions shifted from individuals to professional managers during the 1980s and 1990s demand went up for large caps owing to their greater liquidity.

Looking ahead, Mauboussin sees Asian and petrodollar countries increasingly becoming sources of funds for U.S. stocks via direct channels (e.g. central banks) and through agents such as sovereign wealth funds (SWF) and hedge funds. Both regions will have ever-growing mountains of U.S. dollar reserves to invest and Mauboussin sees evidence that they are beginning to diversify those reserves away from U.S. government bonds into stocks and alternative assets (e.g. SWFs recent investments in U.S. bank stocks).

“This lower risk aversion, in turn, serves to dampen equity risk premiums and ultimately increase valuation multiples,’ writes Mauboussin. “Note that, if true, this analysis suggests an upward re-pricing to gain a new equilibrium [for stocks].” In short, a flood of liquidity from Asian and petrocurrency countries could buoy the U.S. stock market and perhaps over time help lift it out of the current malaise triggered by the housing and financial crisis. Here is the link to his report.