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As US equities market have rallied since the beginning of 2009 -- the S&P is up 3.03% at the time of this writing since the start of the year -- many traders and investors have begun to ask a key question: is this rally a sign of the January Effect?

What is the January Effect?

The January effect is a term given to the tendency of the US stock market to rise in the month of January. In particular, small cap stocks -- generally those with a market capitalization of less than 2 billion USD -- will rise more than mid cap and larger cap stocks. The rationale for the January effect is that investors often sell positions in December with the intent of creating tax losses that can be written off, and then buy them back in January. There is some evidence for that, as the January effect does not seem to be in place prior to 1913, the year the income tax was introduced.

Is the January Effect Real?

There is much debate as to whether or not the January Effect is real. Meaning do stocks actually rise in January? The chart below, courtesy of World Beta, suggests they do. The chart shows the results of trading the January effect over the past 80 years. The red line represents buying and holding the bottom 20% of the US stock market during January of each year; the blue line represents investing in the S&P 500 during January of each year. Both strategies prove to be consistently profitable.

Chart by World Beta

However, as the chart above illustrates, though, returns over the past three years have not been as great as the January effect's heyday back in the '80s. This has caused some to suspect that the market has begun pricing in the January effect, and that it is thus no longer a viable investment strategy. 2008 in particular was a negative year for the January effect. Conversely, those who remain advocates of the January effect will note that it works particularly well in years where the stock market declined in the previous year. This is consistent with the notion that positions will be closed and losses will be recorded for tax reasons, but then re-opened in January to resume the trade.

How Can You Utilize the January Effect In Your Trading Strategy?

Personally, I wouldn't use the January effect; it doesn't fit into my style of trading, and I'm not particularly comfortable with it, especially when I already have my own analysis of the market based on economics and technicals. However, if you're looking to trade the January effect, here are some ideas:

  • Go long the whole market, small caps and large caps, skewing your position to small caps as they tend to do better than large caps during January.
  • Go long small caps and short large caps; this allows individuals to be market neutral while still profiting from the January effect. If I were to trade the January effect now, I would favor this strategy, as I would not want to be long US stocks.
  • ETFs are a great tool for trading the January effect; in particular, PZI, FDM, and IWC are great for playing small caps, while SPY and VTI are great for the larger caps. Inverse ETFs like SH and DOG are also worthwhile if you're looking to short large caps as part of your January effect strategy.

Links to Help You Learn More About the January Effect

Source: Is This Rally a Sign of the January Effect?