Rethinking the Calendar : ‘January Effect’ Seems to Happen Earlier

Some Wall Street pros expect lagging small-company stocks to reassert themselves soon, if the bull market stays on track.

And historically, January has often been small stocks’ best month of the year. So a bet on a powerful “January effect” small-stock rally coming up would seem to carry decent odds.

Or would it?

The January effect refers to the bounce that many small stocks traditionally have enjoyed that month. The bounce, when it has occurred, has usually been attributed to the termination of year-end tax-related selling by Dec. 31 and the traditional inflow of fresh cash into pension and mutual funds on the first of the year.

Fewer sellers and more buyers in the volatile small-stock sector always is a good recipe for a brisk rally, after all.

But the January effect has become so widely anticipated among investors over the last 10 years that some experts wonder if it can happen anymore. One theory is that the January effect has metamorphosed into the December effect.

How so? Investors who want to sell small stocks to lock in gains or losses by year-end may be trying to sell earlier--in November and early December--in an attempt to get better prices than might be available at the end of December.

Meanwhile, more buyers may be emerging for small stocks in early to mid-December, attempting to “front run” what they hope will be big January gains.

None of this is provable, of course: Thankfully, the market is too big to be so conveniently and confidently explained. But the movement of the Russell 2,000 index of small stocks in recent years would seem to suggest that the January effect has indeed migrated backward on the calendar:

* The Russell index has declined in six of the last 11 Novembers, and it has risen in 10 of the last 11 Decembers, a strong hint that tax-related selling is occurring earlier and that buying that might have occurred in January is happening a month earlier.

* Between 1985 and 1992, the Russell index enjoyed bigger gains in January than in December in four of seven periods. Since 1992, however, the index’s January performance has consistently lagged that of December.

This year, for example, the Russell slipped 0.2% in January after rising 2.4% in December.

Will the trend of a “premature” January effect continue? Plenty of investors may have smaller stocks they’ll want to jettison this year to realize tax losses. Even as the blue-chip Standard & Poor’s 500-stock index has been hitting new highs recently, the Russell index remains off 6.7% from its spring peak.

The S&P; is up 13.2% year-to-date, while the Russell is up 7.6%.

But the market for smaller stocks is a crazy quilt this year. The average small-stock mutual fund, for example, is up about 15.5% year-to-date, which is better than the 14% gain of the average blue-chip, growth-and-income fund, according to fund tracker Lipper Analytical Services.

How can that be, with the Russell index lagging far behind the S&P; index? Again, there’s no way to prove it, but it may be that small-stock mutual funds’ average performance is being pulled up by the stellar gains of a relative handful of funds that own the same high-flying small growth stocks.

Through the third quarter, Lipper’s data show that nearly 60% of small-stock funds lagged the average gain for their category.

Meanwhile, the Russell index’s middling performance relative to the S&P; is confirmed by more modest gains in other small-stock indexes as well, including the American Stock Exchange composite index, up just 3.3% year-to-date, and the Value Line geometric index, up 7.5%.

OK, so most small stocks are lagging. Is there a good fundamental reason for them to rally soon?

Philip Orlando, chief investment officer at Value Line Asset Management in New York, believes so. “We think some catch-up [to blue chips] is appropriate, and sooner than later,” he says.

His reasoning is that more investors will soon be focusing on the decelerating earnings growth of many blue-chip firms and looking to stocks of smaller companies that may be able to post faster earnings growth in 1997.

But that assumes that investors will be willing to give up the perceived safety they feel in big-name, highly liquid stocks. That sense of safety has been important for many investors since the wicked July market slump, and so far there is little sign that small stocks can displace blue chips as market leaders.

There also are some wild cards in the deck: The election looms, and it’s hard to figure how markets will react to whatever the outcome is; and in January new rules governing trading in Nasdaq stocks could discourage some brokerages from dealing in smaller issues, increasing their volatility.

If, despite all the uncertainties, you want to bet that recent history repeats--that small stocks decline in November, then rally in December and perhaps into January--what are some easy ways to play the sector?

* Identify individual beaten-down smaller issues that interest you, and decide now on the price range within which you’d like to buy, assuming they get cheaper in November. Get a plan, and be ready to act if the stocks reach your range.

* If you want to invest in smaller issues via mutual funds, there are plenty from which to choose, of course. If you think small stocks will rally spectacularly, you should identify small-stock funds that typically are very aggressive--such as PBHG Emerging Growth ([800] 433-0051), up 18.3% so far this year, or Putnam New Opportunities ([800] 225-1581), up 13.8%.

But note: If you buy those funds before they pay out yearly capital gains, you risk buying an instant tax liability. (See story at right.)

A simpler way to make a broad bet on small stocks: Buy an index fund that mimics the Russell 2,000. Two options: the Vanguard Index Small Cap fund ([800] 662-7447), up 11.4% this year, and the Schwab Small Cap Index ([800] 526-8600), up 10.5%. (Including dividends, the Russell index is in the 10%-plus range year-to-date.)

* For a high-octane bet--one only for people who can take extreme risk--you can buy futures or options contracts on the Value Line and Russell indexes.

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December is Better

Market lore says that smaller stocks tend to jump in January after being beaten-down by tax-related selling in December. But in recent years it looks like the tax selling has occurred in November, moving the “January effect” rally into December. Monthly changes in the Russell 2,000 index of smaller stocks:

Change in Russell 2,000:

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Cycle Nov. Dec. Jan. 1985-86 +6.8% +4.2% +1.5% 1986-87 -0.5 -3.1 +11.5 1987-88 -5.5 +7.8 +4.0 1988-89 -3.6 +3.8 +4.4 1989-90 +0.4 +0.1 -8.9 1990-91 +7.3 +3.7 +9.1 1991-92 -4.6 +7.7 +8.0 1992-93 +7.5 +3.4 +3.2 1993-94 -3.4 +3.3 +3.1 1994-95 -4.2 +2.5 -1.4 1995-96 +4.2 +2.4 -0.2

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Source: Bloomberg Business News