January is usually a pretty strong month for stocks, suggesting that many could see large gains to start the year if historical trends hold true yet again. This is largely attributed to the “January Effect.”

What is January Effect?

January Effect is a seasonal increase in stock prices due largely to year-end tax considerations. Investors redeploy their capital to speculate on weaker performers in January after selling winners in December to create tax losses. This phenomenon pushes the stock market higher in the first month of the year.

While large caps tend to perform better, small-cap securities have historically proven their outperformance in January. According to some market experts, the January Effect actually runs from mid December through February, with the small caps continuing to outperform their large-cap cousins.

January Effect Looks More Real This Year

Small-cap stocks staged a nice comeback in the second half of 2017 on tax reform optimism and accelerating economy; the trend likely to persist in 2018 as well. This is especially true as the corporate tax cut from 35% to 21% is a big boon to small-cap stocks.

Companies on the small-cap index Russell 2000 pay a median effective tax rate of 31.9% while the larger, multi-national companies on the S&P 500 pay a median effective tax rate of 28%, according to the Thomson Reuters data. The median tax rate for the 30 mega-cap stocks on the Dow Jones Industrial Average is even low at 23.8%.

Further, growth in the U.S. economy is on a solid path buoyed by an impressive labor market, higher wages, increasing consumer spending and high consumer confidence. Notably, the economy expanded at the fastest clip in three years in best back-to-back quarters with at least 3% GDP growth and unemployment at the lowest level of 4.1% since December 2000. Americans are highly optimistic about the economy, with consumer confidence hovering near the highest level in 17 years.

Against such a backdrop, small caps seem to be the perfect choice as these are closely tied to the U.S. economy and do not have much exposure to the international market. These pint-sized stocks generate most of their revenues from the domestic market, making them great choices during an uptrend. Further, these companies are small and poised to grow higher than their already tapped out large-cap counterparts. These fundamentals will provide support to the January Effect, leading to rally in the small-cap space.

For investors seeking to capitalize on this opportunity in basket form, the following small-cap ETFs and stocks could be solid pure play choices. These underperformed the broad market last year and are expected to see upside in the first month of the year given their favorable Zacks Rank #1(Strong Buy), 2 (Buy) or 3 (Hold).

ETFs to Consider

ProShares Russell 2000 Dividend Growers ETF (SMDV - Free Report)

This is the only ETF that focuses exclusively on companies listed on the Russell 2000 Index that have raised dividends for at least 10 consecutive years. It holds 60 stocks in its basket with key holdings in information technology, which accounts for one-fourth of the portfolio. The fund has amassed $456.8 million and charges 40 bps in annual fees. It has added just 3.2% and carries a Zacks ETF Rank #3 with a Medium risk outlook.

First Trust Small Cap Value AlphaDEX Fund (FYT - Free Report)

This fund provides exposure to small-cap value stocks using the AlphaDEX methodology. It has 262 stocks in its basket with key holdings in consumer discretionary and industrials with 24.2% and 21%, respectively. FYT has a lower level of AUM at $72.6 million and charges 70 bps in fees per year. It was up 4.9% last year and has a Zacks ETF Rank #3 with a High risk outlook.

Vanguard Russell 2000 Value ETF (VTWV - Free Report)

This fund also targets the value segment of the U.S. small cap market and holds a broad basket of 1405 stocks. About 41.5% of the portfolio is allotted to financial services while producer durables and consumer discretionary also take double-digit exposure each. The product has accumulated $190 million in its asset base and charges 20 bps in annual fees. It has gained 5.6% in 2017 and has a Zacks ETF Rank #3 with a Medium risk outlook.

Stocks to Consider

Bonanza Creek Energy Inc. (BCEI - Free Report)

Based in Denver, CO, Bonanza Creek Energy is engaged in the acquisition, exploration and development of onshore oil and natural gas properties in the United States. The company has seen solid earnings estimates revisions of 30 cents for 2018 over the past month and is likely to generate robust earnings growth of 82.35%. The stock tumbled 75.93% in 2017 and has a Zacks Rank #1 and a VGM Score of B. It falls in a solid Industry Rank in the top 29%.

Bonanza Creek Energy, Inc. Price and Consensus

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Horizon Global Corporation (HZN - Free Report)

Based in Troy, MI, Horizon Global is a designer, manufacturer and distributor of towing, trailering, cargo management and accessory products for original equipment, aftermarket and retail customer. It has seen positive earnings estimate revision of a couple of cents for 2018 over the past month, representing year-over-year growth of 22.08%. The stock shed 41.6% last year and has a Zacks Rank #3 and a VGM Score of A. It boasts a solid Industry Rank in the top 32%.

Horizon Global Corporation Price and Consensus

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Ingles Markets Incorporated (IMKTA - Free Report)

Based in Black Mountain, NC, Ingles Markets operates a chain of supermarkets in southeast United States. Its supermarkets offer various food products, including grocery, meat and dairy products, produce, frozen foods and other perishables, and non-food products; and non-food products, such as fuel centers, pharmacies, health and beauty care products, and general merchandise, as well as private label items. The company sees impressive earnings estimate revision of 45 cents for 2018 over the past month that reflect year-over-year earnings growth of 8.77%. It lost 28% last year and has a Zacks Rank #1 and a VGM Score of A. Further, it boasts a strong industry Zacks Rank in the top 20%.

Ingles Markets, Incorporated Price and Consensus

Bottom Line

January is truly the time to get in on small-cap securities with the above-mentioned weak ETFs and stocks of 2017, assuming that the historical trend holds true in 2018. An improving economy and a booming stock market has also boosted the appeal of these pint-sized products.