Don't Wait Until January To Play the January Effect

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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":

The CBOE study cited above found that, from 1980 to 2006, the Russell 2000 gained an average cumulative 5.16% from Dec. 1 to Jan. 31, compared to an average of 3.32% for both the S&P 500 and the Dow Industrials.

Results put together by Ned Davis Research found that, from 1996 through 2009, a portfolio of 150 of the smallest stocks in the S&P 1500 Index that were also the furthest from their calendar-year closing high gained an average of 8.6% from mid-December to Jan. 31, compared to just 3.5% from Jan. 1 to the end of the month.

Because it includes the so-called "Santa Claus rally," a December start may also be more effective going further back. The Wall Street Journalstudy cited above, while not specifically noting the small-stock effect, found that, from 1900 to 2009, the Dow rose 71% of the time in December, by an average of 1.5% – even better than the January advance.

Our own review of the past two years found a similar December-January pattern:

In 2009-2010, the S&P 500 rose from 1,105.98 at the open on Dec. 1 to 1,150.41 in mid-January – a gain of 4.0% – before plunging to 1,066.19 on Jan. 29, giving it a loss of 3.59% for the full two-month period. By contrast, the Russell 2000 rose from 602.79 on Dec. 1 to 649.15 in mid-January – a gain of 7.69% – before pulling back to 592.98 at the end of the month, a loss of just 1.62% for the two-month period.

In 2010-2011, the S&P 500 rose from 1,186.60 at the open on Dec. 1 to a high of 1,296.06 on Jan. 18, a gain of 9.62%. It then pulled back slightly to finish January at 1,276.50, giving it a gain of 7.57% for the two-month period. Meanwhile, the Russell 2000 went from 727.00 to a mid-January high of 807.57, a gain of 11.08%, finishing the month at 798.89 for a two-month gain of 9.88%. (Note: Those numbers are actually skewed to the downside because the market advanced sharply the final two days of November.)

Three Ways to Play the January Effect

If you hope to achieve maximum gains from this year's January Effect – should it actually develop – it's probably best to start right now, using one of three approaches:

1) Buy individual small-cap stocks or beaten-down issues poised for recovery. The best way to find top prospects is to screen for stocks that are trading within 15% of their 52-week low, but have good fundamentals – e.g., positive earnings and a favorable Price/Earnings (P/E) ratio – and some positive analyst recommendations. Two good examples are:

Nokia Corp. (ADR-NYSE: NOK), recent price $5.61 – This technology company, which has a strong presence in the cellular and mobile communications sector, fell sharply from its February high of $11.73, but has bounced nicely from its recent low of $4.82. Earnings for its current fiscal year are estimated at 36 cents a share, giving it a P/E of 15.6, and it has buy, overweight or hold recommendations from 44 of the 65 analysts who follow the stock.

IRIDEX Corp. (Nasdaq: IRIX), recent price $3.65 – Down from its April high of $4.65, but up nicely from its recent low of $3.08, this maker of medical laser devices for eye surgery and dermatology treatments has a P/E of 14.7 based on projected current-year earnings of 25 cents a share. With a market cap of around $33 million, the stock has limited analyst coverage, but the current recommendation is a solid buy. Volume is relatively light, so use a limit order when purchasing bigger share blocks.

2) Buy exchange-traded funds (ETFs) that track small-cap indexes. This lets you play the potential December-January advance without having to worry about selecting individual stocks. The two funds best suited for this play are:

The iShares Russell 2000 Index ETF (NYSE: IWM), recent price $69.81 – This fund seeks to track the price and yield performance of the Russell 2000 Index, the market's broadest measure of small-cap stocks. With a market capitalization of $13.08 billion, its portfolio has a P/E of just 5.43 and it provides a yield of 1.47%. The shares are well off their 52-week high of $94.35, but have rebounded nicely from their September low of $60.09.

The iShares S&P Small-Cap 600 Growth ETF (NYSE: IJT), recent price $70.65 – This fund follows a subset of the S&P Small-Cap 600 Index with the strongest growth characteristics. Though smaller ($1.44 billion in assets) and more focused, this fund has outperformed the broader Russell 2000 ETF in recent years, gaining 10.2% from Dec. 1, 2009, to mid-January 2010 before falling back to lose 0.69% for the full two-month period, and gaining 8.78% in December 2009 – January 2010 versus the IWM's 7.21%.

If you're particularly bullish on the small caps this year, a third alternative would be the Direxion Daily Small-Cap Bull 3X ETF (NYSE: TNA), recent price $38.34. It tracks the Russell 2000, but uses leverage to produce returns roughly three-times those of the Index on upward moves. Of course, losses are also magnified if the small caps slide.

3) Use options to either reduce costs and risks or to profit with a smaller investment. There are several ways to play the January Effect with options, but the two best are:

Buy a small-cap stock and sell an out-of-the-money January call option against your position. This provides a cushion against a loss if your small stock fails to advance, but also limits your potential gain on a big rally. For example, if you bought 500 shares of Nokia Corp. at $5.63, laying out $2,815, you might simultaneously sell the January $6.00 call option, priced around 40 cents, or $40 per contract. That would bring in $200, cutting your cost to $2,615 and protecting you against a decline in Nokia's price to $5.23. However, if Nokia rose sharply, you'd have to sell your shares at $6.00 – but that would still give you a gain of $385 (37 cents on the stock, plus 40 cents on the option x 500 = $385), or 14.72% in just seven weeks.

Position a bullish option spread. This would involve buying an at- or slightly in-the-money call option and simultaneously selling an out-of-the-money call with a higher strike price. With the Russell 2000 ETF at its Monday price of $69.71, for example, you might buy the January $70 IWM call at $3.75 a share (or $375 per contract) and sell the January $73 call at $2.35 a share. This would give you an opening debit (cost) or $1.40 per share ($140 per contract) – much cheaper than merely speculating with an outright IWM call purchase – though your profit would be limited to $1.60 (the $3.00 difference between the strike prices, less the $1.40 cost) if the ETF price rose above $73.00 by Jan. 20, when the options expire. Still, that would be a gain of 114.2% in under two months.

With that many profit possibilities available, it's hard to resist making a play on the "January Effect." You just need to think a month or so ahead of the crowd – and start thinking about a possible new name for this long-time seasonal pattern.

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