It’s About Time to Take Advantage of the ‘January Effect’

Looking for a good way to play the stock market in the next few weeks? One possibility: Buy small stocks toward the end of this month.

Under a phenomenon called the “January effect,” many academic researchers and market analysts have shown that smaller, riskier stocks generally outperform blue chip issues in the first two or three weeks of a new year. The pattern, due in part to year-end selling by individuals and institutions, is regarded by some experts as about as reliable as any pattern around.

“It’s a pretty good bet,” says Peter G. Eliades, editor of Stockmarket Cycles, a Los Angeles newsletter.

Between 1938 and 1987, small stocks have outperformed the blue chips in Standard & Poor’s 500-stock index by an average of 5 percentage points in January, says Robert A. Haugen, a UC Riverside finance professor and co-author of a new book, “The Incredible January Effect.”

There were only four years in that period when the effect did not happen: 1939, 1969, 1974 and 1987, Haugen says. It would have happened this year if only the first two weeks of January were counted, he says, noting that the Dow Jones industrial average rose 9.22% in that period while the NASDAQ composite index of over-the-counter stocks gained 12.54%.

In the first two weeks of 1986, the Dow fell 1.25% but the NASDAQ composite was up 1%, Haugen notes. In the first two weeks of 1985, the Dow gained 1.59% while the NASDAQ index rose 4.22%.

Also, January has shown to be by far the best month for stocks in general, Haugen says. This phenomenon over the decades has been so strong that if you removed the first two weeks of January as well as the last trading day in December and the days before holidays (also good days for stocks), the gains from stock investing would on average have been about zero, Haugen claims.

The January effect is not just confined to stocks or to the United States, Haugen argues, but also occurs in foreign stock markets. In Japan, for example, small stocks outperform big stocks in January by even a greater margin than in the United States. And the same effect hits bonds, with higher-risk “junk bonds” showing their greatest total returns in January over safe Treasury bills, Haugen says.

Why does this happen? At least for stocks, the most often cited cause is year-end tax selling by individual investors to establish capital losses for tax purposes. Individuals tend to hold a higher proportion of smaller stocks than do institutions. Individuals’ year-end selling depresses prices of those smaller issues, making them look like bargains, whereupon they are snapped up in late December or early January by other individuals, driving their prices higher.

Another cause may be individuals investing year-end bonuses, says market historian Yale Hirsch, editor of Stock Trader’s Almanac. Stock dividends also tend to be paid in early January, Hirsch says. And individuals may simply view January as a new beginning, at least in odd-numbered years, when a new Congress or President takes office.

UC Riverside’s Haugen suggests another reason that he claims is even more pervasive than year-end tax selling. Institutional money managers, he says, tend to unload smaller stocks late in the year and buy them back on Dec. 31 or early in the new year.

That’s because these managers’ compensation is based on how well they outperform the S&P; 500. So, if they have done well through most of the year, they shift their portfolio away from smaller stocks and into components of the S&P; 500, in effect locking in their gains. On Dec. 31 or in early January, they sell those blue chips and go back to small or undervalued stocks that they think will outperform the S&P; 500 in the new year, Haugen argues.

Institutional money managers also tend to unload undervalued stocks in order to dress up their year-end reports to clients. They want to unload the dogs and put in more winners.

But if enough professional speculators and other investors know about the January effect, won’t they wipe out it out by buying small stocks and thus preventing them from falling too far? Theoretically, that should happen but in reality it hasn’t, in part because as many as 5,000 to 10,000 stocks are involved in the January effect, Hirsch says. “You’re dealing with some pretty big numbers” of stocks, he says.

Not Without Risk

Also, UC Riverside’s Haugen contends that only a small number of professional traders--particularly in foreign markets--are aware of the January effect.

So should you buy small stocks soon to take advantage of the January effect? Not necessarily, experts say. The January effect is not a sure guarantee of profit.

Although the effect is pretty reliable, there’s always the risk that stocks overall will go down. In that case, small stocks will simply go down less.

Hirsch points out that while the January effect occurred in the bulk of the years since 1950, the S&P; 500 rose in January in only 23 of those years while falling 15 times. The most recent declines occured in 1984, 1982 and 1981, Hirsch says.

“I would tend to think that this January will be down,” Hirsch says, noting that this is now a bear market and “people have been frightened by the crash.”

“The January effect may be minimal this time, because there are so many stocks that are tremendous bargains, but nobody seems to be interested in them,” Hirsch says.

“It’s not a risk-free strategy,” UC Riverside’s Haugen says. “If you believe the market is going to go down in general, you should stay out of the market.”

Check Out Small Stocks

However, if you have some of your money in equities anyway, consider putting it in small stocks for the late December-January period, Haugen says.

One strategy: Invest in small stocks setting new lows in mid-December, Hirsch suggests.

Better yet: Invest in no-load mutual funds specializing in smaller stocks.

This will reduce commission costs, save time and provide diversification.

No-load small-stock funds suggested by Haugen include Acorn Fund (312-621-0630), Dreyfus New Leaders (800-645-6561), Vanguard Explorer II (800-662-7447), T. Rowe Price New Horizons (800-638-5660) and Scudder Development Fund (800-453-3305).

Haugen also suggests investing in no-load funds investing in small stocks overseas. They include G. T. Pacific Growth (800-824-1580), T. Rowe Price International (800-638-5660), Scudder International (800-453-3305) and Vanguard World International (800-662-7447).