Archives for November 2011

A lot of investors have pocketed big gains from the so-called "January Effect." In fact, the January Effect – which refers to the historical tendency for stock prices in general, and small-caps in particular, to rise during the first month of the year – has better than an 80% success rate since the mid-1920s.

Of course, based on recent performance, the phenomenon may soon require a new name – and some new timing guidelines for traders hoping to profit from it.

The January Effect was first recognized in the 1940s, but its actual strength wasn't quantified until 1982 when Donald B. Keim, now a finance professor at the University of Pennsylvania's Wharton School of Business, presented research detailing the market's January performance superiority dating back to 1925.

Since then, studies by several other groups have verified Keim's results – both in terms of positive overall January performance and the extra strength of small-cap stocks. Some of the findings include:

• Stephen Ciccone and Ahmad Etebari, professors at the University of New Hampshire's Whittemore School of Business and Economics, reviewed stock market performance from 1926 to 2006 and found that January produced "the highest returns of any month of the year." Their study determined January posted positive returns 81.48% of the time, fueled by "outstanding small-firm performance."

• Research by The Wall Street Journal, reported in early 2010, found that from 1900 through 2009, the Dow Jones Industrial Average rose 62% of the time in January, while the Nasdaq Composite Index was up in 67% of the years studied, affirming the small-cap advantage.

• The Chicago Board Options Exchange (CBOE) found that from 1980 through 2006, small-cap stocks as measured by the Russell 2000 Index averaged a return of 2.5% in the month of January. That compared to respective January returns of just 1.7% and 1.6% for the Standard & Poor's 500 Index and the Dow.

• A 2003 study by Ibbotson Associates, now a part of Morningstar Inc. (Nasdaq: MORN), found that, from 1926 through 2002, the smallest 10% of U.S. stocks outperformed the largest 10% of U.S. stocks by an average of 9.35 percentage points during the month of January. That included both up and down years, though the broad market lost ground in January only seven times during that period.

All of that would seem to be a fairly strong endorsement for playing the January Effect – but there's one small problem: In recent years – most likely due to an increased awareness of the pattern and more traders trying to play it – the upward move in the market that typifies the January Effect has actually started in December.

In fact, since January 2000, the broad market (as measured by the S&P 500) has shown a decline from Jan. 1 to Jan. 31 on seven occasions – in 2001, 2002, 2003, 2005, 2008, 2009 and 2010.

However, if you move the beginning of the January Effect time period back to December and look for a top in mid-January, the success rate returns to near its historical norm, with only two years – 2002-2003 and 2005-2006 – showing broad market declines.

Small stocks, as measured by the Russell 2000 (which currently has a median capitalization of $473 million), also continued to outperform larger ones in all but two years – 2004-2005 and 2001-2002 (when the two indexes were virtually even). However, in a few years, like 2002-2003 and 2008-2009, the advantage came in the form of smaller losses.

The exact starting date of a December-January Effect move isn't precisely identified by the newer studies, but a quick glance at the numbers indicates the smartest approach may be "the-sooner-the-better":