Wednesday, December 18, 2013

Profiting in Stocks from the January Effect

The January Effect — Another Strategy That Works (With a Twist)

By Dr Van Tharp Trading Education Institute

The Christmas season is a time of year that has a different vibe, regardless of one’s spiritual leanings. The pace around us quickens, expectations rise, and for those of us who can see past the blatant commercialization that seems to accost us from all directions, some of the joy and love of the season seeps in. I’m looking out my window right now at almost a foot of snow — that certainly seems seasonally correct. Family members are calling to arrange visits for later in month. And we have a few decorations set out that provide a pleasant reminder for our personal reason to celebrate. My kids are coming home from college in just two days; so when combined, I can say that I’m certainly in a state of joy. It’s a nice place to be.

The markets usually manage their own form of “joy” at this time of year as the optimism of the populace seems to bleed over into stock prices. This observation is backed up by the fact that the S&P 500 index has provided positive returns in December in 48 of the last 63 years for a win rate a little above 76%.

Has the January Effect Been Affected by Recent Events?

Many readers will have heard of the January effect where small capitalization stocks have historically outperformed their large cap brethren during the month of January. This was very clear in the second half of the 20th century with Hirsch and Hirsch reporting in the Stock Trader’s Almanac that small caps far outperformed big caps during January in 40 out of 43 years between 1953 and 1995. During that time, small caps gave a staggering absolute performance improvement. The Wall Street Journal reports that small cap outperformance of 5.1% vs large caps during the decade of the 1970s. To say it another way, a $100,000 portfolio invested in small caps would return $5,100 more than one invested in only large caps during the month of January. That’s a huge edge.

Since then, it seems like everyone has jumped on this band wagon and the edge has steadily diminished down to only a 1% edge in the 1990s.

However, there is good news (that is coming up fast upon us) on the small cap outperformance front. The Hirsch father and son team have reported that January effect is still working, it’s just working earlier. Since the 1987 crash, moving the entry date back to December 15th has worked wonders. The numbers show a small cap outperformance from 12/15 to 12/31 of 85% (3.5% vs. 1.9%). The effect remains viable, though weaker if held through the middle or end of January.

And the last two years have built on that outperforming tendency with December of 2012 having a very strong showing for the small caps vs. large caps.

In short, this is a seasonal tendency with a strong track record that is built on a broader foundation of overall market strength in December. Like all seasonals, it won’t work every year, but this one merits a close look and perhaps a trade with your normal risk parameters attached.

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