How to Get the January Effect to Work in Your Favor

The market phenomenon known as the “January effect,” where stock prices tend to rise early in the year after tax-loss selling in December, is said to impact smaller stocks more than mid or large cap names.

The trend is well-documented but recent research has shown that it has been declining. However, some evidence has emerged that the January effect is still significant and traders are not actively arbitraging the anomaly, according to Macquarie Securities quantitative strategist Yin Luo.

While tax-loss selling is the most common theory people adopt to explain the annual trend, he said the question remains an open one. For example, the market moves could be driven by firms that exhibit earnings information uncertainty, which naturally is greater for small cap stocks. The strategist also noted that the momentum effect tends to disappear and quality tends to fail in January.

He conducted a statistical testing of the January effect on more than 700 factors in the U.S. and 400 in Canada. What he found was that most traditional style factors reverse trend in January for U.S. stocks. For example, the best time-proved value strategy, trailing earnings yield, completely reverse trend. At the same time, most long-term and short-term growth styles also underperformed in January.

Noting that short-term price reversal demonstrated the best performance, he told clients:

Expensive, low-growth, weak-momentum, negative-sentiment, poor-quality, small-size, and high-beta stocks are likely to shine in January. Quality factors also lost their hedges in January – across the board from profitability, earnings quality, leverage and default risk, and earnings stability.

Other strategies that performed surprisingly well in January include price-to-book and high beta. Since well known quantitative factors underperform, Mr. Luo recommends investors lower their active risk in the month.

While the January effect in Canada is somewhat similar to the U.S., the strategist found two interesting exceptions: price momentum and analyst revisions. “Momentum and revision strategies are more likely to survive the January reversal in Canada,” he said, suggesting investors overweight these approaches in January, while underweighting value, growth, quality and trading factors.

Mr. Luo also found that the number of months or years a company has been in existence plays an important role for decision makers. Since younger firms have less of a track record, it makes earnings more difficult to forecast. He noted that these names tend to deliver suboptimal returns as a result.

In the U.S. market, but not in Canada, younger companies seem to benefit from the January effect as they are more likely to recover strongly in the first month of the year along with small cap stocks.

Comments

[mcadoo3312:]

From what I have seen, the January Effect has been very nice in 2009. Still, it is up to the investor to do the research to realize which stocks are increasing because of arbitrage versus those that are increasing because of fundamentals of their companies. Small caps always exude the biggest risk/reward; diversify, be diligent, and ask yourself if you are being greedy when expecting future profits.

Jan 08 07:26 PM