With the end of the year approaching, traders already are planning how to start the new year on the right foot by playing the so-called “January Effect.” Great — but what is it, and how can investors tap into it? And more than that, is there any merit to the idea? Glad you asked.
The January Effect(s)
Actually, there are three theories that generally are referred to as the January Effect.
The more-commonly understood one is the assumption that the tone set in the first month of the year often indicates how the market will perform during the following 11 months — a positive January means the market is on pace for a gainful year, and a bearish January paves the way for weakness through the following December. Ergo, keeping a watchful eye on how things shape up in January might help long-term investors navigate the rest of the year.
Another January Effect is the idea that small and beaten-down stocks tend to outperform larger and recently strong ones over the course of the first month of the year. Clearly, this is more of a trader’s approach, as the effect only lasts a month or so.
The third version of the January Effect is a variation on the second. It simply says that the first five trading days of the year are enough indication of what (and how) traders are thinking to set the tone for the year. In other words, if the first five days of 2012 are bullish, the whole year will be as well. If the first five days are bearish instead, well … that’s not encouraging.
Is there any truth to any of the axioms? Yes and no. So, before you bet the farm on one of the premises, you might want to know whether these January Effects have a fruitful history — or if they’re just more misguided assumptions.
Small Caps Versus Large Caps
While the historical numbers can vary from one researcher to the next, they all generally point in the same direction: Small caps usually do outperform large caps during the first month of the year.
For example, Bank of America Merrill Lynch strategist Steven G. DeSanctis has found that the Russell 2000 Small Cap Index has outperformed large caps more than 70% of the time since 1926. He also notes that January usually is the best month for small caps; they’ve averaged a gain of 4% in that month.
University of Kansas professors Mark Haug and Mark Hirschey broadly confirmed the idea, discovering that between 1927 and 2004, small-cap stocks outperformed large caps by an average of 2.5% in the first month of the calendar year.
Point being, the math supports the assumption. And for many investors, the historical results alone would be enough to make the bet. For other investors, though, the reason for the results still has to be clear. That’s where the strategy can hit a wall — it’s not clear why it happens.
There is a common theory, however.