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Historically stocks of small-cap companies had seasonal tendency of outperforming the large-caps around the turn of the year, specifically during January. The existence of this January Effect of stock market return has been widely known. In back testing, researchers have found that it existed in many prior decades. Since 1950, there have been only five times when the January effect turned out to be a poor indicator of the rest of the year, according to the "Stock Trader's Almanac," a book that tracks market trends.

The January effect is different from January "factor" or January barometer which often sets the tone for the rest of the year. The January barometer is the first five days of the month, tend to be a good predictor for the rest of the month and the rest of the year. Because people are putting money to work, they're finding new sectors at the beginning of the year. As goes January, so goes the whole year. Those who wish to get a head start on their 2010 forecasting tend to look at the first-five days of the January barometer. This pattern has a success rate of 80%+ over the past 38 years. Stocks were up at the start of January 2009, although they were at 12-year lows two months later, they ended the year having had their best performance since 2003.

There are some theories behind this January effect stock market anomaly. Two possible explanation on the January effect are that investors’ activity of buying back into beaten-down small-caps, which were probably sold for tax loss harvesting and window dressing reasons late in the outgoing year. Others speculate that the phenomenon has something to do with less information flow of small cap stock during the year.


Window Dressing

The January Effect phenomenon may happen because investment managers and other institutional investors, who sell off the shares of riskier small companies to make their end-of-year balance sheets look better, then buy them back early in the new year. We often observe artificial selling pressures on riskier stocks that come from portfolio window dressing in December and investment managers’ eagerness to invest back into riskier stocks in January.

It has to do with the benchmark that managers must outperform for their year-end success. The most commonly used benchmark is the large cap S&P 500 index. As a more speculative play than the S&P 500, small-cap stocks have a greater possibility of larger than average returns and losses. Therefore, at the beginning of a year, if small-cap stocks receive a good push, it can put fund managers well ahead of their respective benchmarks. If managers gain a lead, then they could simply mimic the S&P 500 for the remainder of the year and come out ahead.

Consider a manager who is ahead of the S&P 500 for year-to-date performance as the end of the year approaches. To hold on to his lead above the S&P 500 until Dec. 31, he will have an incentive to make his portfolio look more and more like the S&P 500. That means he will tend to shift money out of stocks that are not part of the S&P 500 and into the large caps that dominate that index.

Investment managers who are only moderately behind the S&P 500 as the end of year approaches also will have an incentive to reorient their portfolios to be more like the S&P 500. Their fear of losing their bets and lagging the S&P 500 by an even large margin motivates them to take less risky approach.

The managers are more likely to dump their losers over weeks prior a year end for window dressing. These investors are going to want to get the most controversial stocks out of their portfolios soon so that the names won't show up in their year-end reports. And, of course, losing positions are always much more controversial than winners.

Come New Year's Day, concerns about year-end reports will disappear. Managers willingness to take risk will be at the highest point it will be all year. Appetite for higher risk often manifests as an eagerness to bet on small-cap stocks. Furthermore, many of the stocks that were being dumped in December will suddenly look quite attractive when investors once again focus on fundamentals. Those in turn mean that managers in January will likely be net sellers of the large caps that they increasingly purchase in November and December.


Tax Loss Harvesting

We also often observe artificial selling pressures that come from tax-loss selling in December. Investors who sold stock before the end of the old year to claim a tax loss reinvest that money when trading begins again.

For taxable investors, market movements both in the broad market and in particular sectors over the course of the year may leave investors with both big winners and big losers in their portfolios. If they want to cash out their winners, they are likely to sell losers as well to offset the taxable gains from the winners. This approach is known as tax-loss harvesting.

Same as what happens in window dressing, concerns about taxes will disappear as New Year's Day comes; and many of the stocks that were being discarded in December will look quite attractive when focus is aimed on fundamentals.


Information Flow

Others speculate that the January effect is most pronounced among small-cap stocks because of information flow of the small-cap stocks. There's generally less information available regarding small stocks, and much of the news tends to be released at the end of the year. Thus, investors may be best informed and ready to buy small caps in January.


January Effect Caveats

Abnormal market condition around the turn of the year influences January Effect strategies. If investors panic around the turn of the year and there is a market-wide flight to quality as what happened in December 2008, the January Effect strategies were not appealing. While both large caps and small caps declined, small caps suffered the most. As a result, January Effect strategies turned a loss in January 2009. Investors have learned that no matter what has happened in the past, the future is just too hard to predict

January effect has became weaker in the recent period, since 1970, would be explained by the activities of investors who try to take advantage of the anomalous behavior of stock returns.


Tracking January Effect

Investors can tell if a January effect is under way this year by comparing the performance of small-cap stocks to large-caps stocks. A simple method of doing this is to compare the following two exchange-traded funds: the iShares S&P 500 ETF (IVV) and the iShares Russell 2000 small-cap ETF (IWM).


Betting on the January Effect

If you are willing to make that bet, exchange traded funds probably provide the easiest investment vehicles with which to do so. You would purchase an ETF that invests in small-cap indexes, such as the iShares Russell 2000 fund (IWM) or Vanguard Small Cap (VB), while simultaneously shorting an equal dollar amount in an ETF that invests in the S&P 500, such as the iShares S&P 500 fund (IVV ) or Vanguard Large Cap (VV).

Not all January Effect strategies use the same entry and exit dates. A study used Dec. 20 as the entry (or the close of the first trading session after Dec. 20 if the market was closed on that day), and Jan. 9 as the exit.

 

 

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Tax-Loss Harvesting