The January effect is the tendency of low price, small-capitalization stocks to outperform in January. Historically, these are stocks that were sold for tax reasons late in the prior calendar year and repurchased the following January because investors still think the stocks are fundamentally attractive. Since individual investors using this strategy must wait 30 days before repurchasing any stock sold at a loss to avoid triggering the wash sale rule, these stocks can decline in December and rise in January. The wash sale prevents a loss from being realized if a substantially identical security is repurchased within 30 days of a sale.
Due to the uncertainty about 2013 tax rates, it is possible that we are seeing some stocks getting set up for a large-cap version of the January effect. In this case, the selling pressure could be coming from investors wanting to realize long-term gains at the known tax rate of 15%, rather than risk a potentially higher tax rate in 2013. Individual investors who sell a stock to realize a capital gain can repurchase the stock immediately and reset their cost basis to a higher level. They must wait 30 days to repurchase the stock, however, if they want the flexibility of writing off a potential loss on the new position.
Market observers don't get detailed reports on why a stock is being sold. As you know, online discount brokers do not ask you why you're selling when you place an order to do so. Thus, we rely on a combination of news events, surveys and analysis to identify plausible explanations. For example, there are large-cap stocks with a good 52-week performance, lackluster four-week returns and comparatively attractive valuations. This combination suggests the possibility of capital gains harvesting at known tax rates.
To find these stocks, I created a simple screen in our Stock Investor Pro stock screening program that looks for stocks with four specific characteristics. First, all passing companies had to be members of the S&P 500, thereby limiting the universe to large-cap stocks. Second, passing companies must have had 52-week relative strength rankings of 75% or higher. This restricts the universe of large-cap stocks to only those whose 52-week price gains ranked in the top quartile of all (not just large-cap) stocks. Third, passing stocks were required to have declined in price over the past four weeks, as of December 7, 2012. If tax-related selling is occurring, then the share price should show some recent weakness. (Requiring a four-week relative strength rank of below 50% instead would have identified a few more companies.) Finally, the current price-earnings ratio had to have been below the stock's five-year average. I included this component to limit the passing companies to those trading at valuation levels below what investors have typically paid.
(For those of you wishing to replicate the strategy, the specific search terms I used in Stock Investor Pro were Company Information: Standard and Poor Stock equals 500; Rank: % Rank-Rel Strength 52-week >= 75; Price and Share Statistics: Price Change 4 week < 0; and Multiples: PE < PE-Average 5 years.)
A list of the passing companies is presented in the table below. Since this is a very basic screen, be sure to do further research before buying any of the stocks. Also, be sure you like the long-term prospects, as there is no guarantee a January effect will lift these stocks. The data may fit the theory, but there is always the risk of the theory not working in reality.
Table 1. Top-performing large-cap stocks that have recently declined in price.
|Company||Ticker||4-Week Return (%)||52-Week Return (%)||Current P/E||5-Year Average P/E|
|Capital One Financial Corp.||(NYSE:COF)||-2.23||27.62||9.5||71.7|
|Franklin Resources, Inc.||(NYSE:BEN)||-0.95||32.34||14.3||15.7|
|M&T Bank Corporation||(NYSE:MTB)||-1.46||35.69||15.2||15.4|
|Quanta Services Inc||(NYSE:PWR)||-0.27||28.94||20.2||28.4|
|Williams Companies, Inc.||(NYSE:WMB)||-2.65||22.86||29.5||35.6|
*Source: AAII Stock Investor Pro. Data as of December 7, 2012. We currently hold both Apple and U.S. Bancorp in our Stock Superstars Portfolio.
Disclosure: I am long AAPL, USB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We hold Apple and U.S. Bancorp in our Stock Superstars Report portfolio.