When you’re investing in small cap stocks, “seasonality” is a key word. Historically, small-caps have underperformed large caps in the July to November time-frames of all calendar years, only to sprint ahead and outperform large caps after the elections and into the new year.

For whatever reason, small caps have tended to underperform in midterm election years as well – such as 2014. But they tend to come roaring back the following year.

There are a lot of fears right now that a higher U.S. dollar will hurt corporate earnings through a “triple whammy” effect of: (1) driving up the costs of doing business overseas, (2) suppressing the value of non-U.S. sales, and (3) signaling weak international demand. However, the dollar may be overbought in the short-term, having risen for 12 consecutive weeks prior to this week. The dollar suffered its largest one-day drop in more than a year on Monday, Oct. 6^th.

Bearish seasonality may also have played a role. There typically is some autumn stock-market weakness in mid-term election years and historically the worst-performing month of the year is September, so now was a predictable time for a temporary interruption in the current bull-market rally to occur. The stock market has not suffered a 10% correction in more than two years (more than 575 trading days), which is longer than double the average length between corrections, but not unprecedented (eight periods have been even longer).

The S&P 500 fell 1.6% in September, so the month held true to historical bearishness. The small-cap Russell 2000 index performed much worse in September, down 6.2%, but should be bottoming. Over the past three years, every few months the stock market experiences a dip of a few percentage points, only to climb to new highs afterwards.

The bottom-line is this: if the pattern of the past two years is still driving the market’s playbook, then a re-test of recent highs is on the way. Enough extremes in shorter term measures of market stress have been reached in the past two weeks to mark a washout. But price declines may continue for another one to two weeks before reversing.

The key missing element is time. The down cycles have become increasingly short. This one was less than 2 weeks. One reason to expect a larger sell off is that that has been a pattern during mid term election years. As an example, in the past four mid-term years, SPX has sold off by 8%, 16%, 20% and 34%; from its high to its eventual low has taken 2-6 months.  

In the past six months, the largest correction was 4.6% and took just 10 days. Another reason is that SPX will have traded above its lower Bollinger band for 22 months by the middle of this coming week. That is four months longer than even the powerful 1995-96 period.

The S&P 500 Volatility Index (VIX) is also flashing a bearish signal. As one market strategist noted:

Right now the VIX high for the year was in February: 21.44 on February 3. If you go back 25 years to the beginning of the VIX, it’s never topped out in February. October is typically a very high volatility month.

I do expect that we get a pullback that rolls through the first half of October. It’s seasonally right. We’ve had a lot of complacency.

If there is market weakness over the next month or so, the odds of a market rally into year-end are very good because U.S. economic news is positive with no recession in sight. Positive economic news in the U.S. includes:

• September non-farm jobs increased 248,000 which beat analyst expectations and the unemployment rate fell to 5.9%, the lowest it has been in more than six years (since July 2008). On the other hand, the labor participation rate hit a 36-year low , the jobs growth included  the return of 20,000 striking workers, and average hourly earnings were stagnant.
• Second-quarter U.S. GDP growth revised up to 4.6% from a revised 4.2%, which itself was higher than the initial 4.0% estimate. The 4.6% figure marks the strongest economic growth in almost three years.
• U.S. dollar index rose to its highest level in more than four years.
• New home sales in August surged to more than a 6-year high.

Three Federal Reserve bank presidents have warned against raising rates too quickly, stating that the strength in the U.S. dollar would lower inflationary pressures through lower import prices. Economic weakness in China, Japan, and the Eurozone will all continue to prop up the U.S. dollar and limit U.S. economic growth, with Chinese weakness the biggest negative  influence.

The fourth quarter of midterm election years is historically very strong. Even better, when the historically- weak May through October period acts against its nature and is a bullish period, the odds of this bullishness continuing in the following three months of November through January is over 90% and with an average positive return of more than 5%. Furthermore, a Dow Theory buy signal was triggered in late-September that suggests stock prices will rise further, perhaps by 20%. Value investors should also take heart in knowing that the greatest value investor of them all, Warren Buffett, took advantage of the recent market downdraft to buy stocks, telling CNBC: “The more the market goes down, the more I like to buy.”

Bottom line: For now, I would stay invested because the Ivy Portfolio market-timing system based on the 10-month moving average remains on a “buy” signal for U.S. stocks, bonds, and real estate (sells are foreign stocks and commodities).

Yes, U.S. small-caps have underperformed in 2014, but history and financial theory argue that buying more small caps when they’re down should really pay off soon.