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The "January effect" is a market anomaly whereby stock prices tend to decrease year-end followed by a subsequent increase in the month of January. This phenomenon has been observed repeatedly over the past 70-plus years, but has weakened of late due to more investors becoming aware of its presence in the marketplace. The generally accepted hypothesis for the January effect is that money managers and retail investors alike tend to begin dumping underperforming -- or more speculative -- assets toward the end of the year, causing a subsequent decline in their price per share. As a result, these assets are then viewed as oversold or undervalued, spurring a new round of buying in the first quarter of the new year.

This phenomenon is obviously nothing new, and professional money managers have taken advantage of the January effect year after year, lessening the ability of retail investors to take advantage of this arbitrage type of play. Even so, there are a fair number of stocks in the biotechnology sector right now that are clearly experiencing the January effect. If investors are willing to risk some additional downside over the coming month to beat institutions to the punch, they should be able to see a healthy return on their investments in the new year.

After researching a large number of biotech stocks, I believe the following three stocks are strong candidates to exploit the so-called January effect, due to the fact that they are being sold off in the fourth quarter at astonishing rates.

1. Arena Pharmaceuticals (ARNA). Arena is engaged in the development of G-Protein-coupled receptor compounds (GPCR) aimed at treating unmet medical needs. Chief among these novel compounds is lorcaserin, known commercially as Belviq. Belviq is the company's recently FDA approved drug for the treatment of obesity, and is expected to be a major blockbuster within two to three years from its launch. ARNA stock was recently undergoing wild oscillations between the $8 and $10 range, and this pattern has generally repeated since it received FDA approval last June. Presently, however, the stock has broken support and sunk into the low to mid-$7s, indicative of the January effect. As the company failed to give clear guidance on DEA scheduling for Belviq during its recent conference call, I believe money managers saw this as a sign that the stock will underperform the rest of the year and did not want it showing up in their year-end reports -- not to mention the dreadful sales numbers of its competitor, Vivus.

The stock is now down 24% from its recent highs, and it may go even lower before the end of the year now that support has been broken. However, ARNA should be an excellent year-end buy for those looking to profit from the January effect. DEA scheduling shouldn't go long than December, as per the company's recent statements at investor conferences, thus triggering a milestone payment of $65 million from its partner Eisai Pharmaceuticals and the subsequent launch of Belviq in North America. Moreover, Arena is slated to give a number of presentations at investor conferences in the coming months, which should increase awareness of the company's significant research and development activities in the GPCR arena. As such, this stock should easily climb back into double digits by mid-January.

2. Dendreon (DNDN). Dendreon engages in the development and commercialization of novel cancer immunotherapies, and its flagship product is PROVENGE (sipuleucel-T), an autologous cellular immunotherapy for the treatment of prostate cancer. Shares of Dendreon are down an unholy 46% for the year due to an array of poor management decisions, followed by underwhelming sales figures for Provenge. Moreover, DNDN is down 10% from its recent three-month highs, and it has broken support at $4 recently. I believe this recent breakdown in PPS is a clear indicator of money managers dumping DNDN before the year is out.

Even so, there are reasons to be optimistic for DNDN going into 2013. The company has begun to reverse direction on its revenue, and is performing new clinical trials to expand the use of Provenge. Personally, I would not hold this stock long term because another round of dilutive financing certainly looks as if it's coming down the pike, but DNDN should show a strong short-term move toward $5 in the beginning of 2013 due to the January effect alone. However, the stock could move much lower heading into December now that support has been broken. If you plan on buying DNDN for the January effect, I would look for an entry point somewhere in the mid-$3s. Simply put, there is no catalyst to drive this stock higher in the short term, and therefore it should continue to sink for the remainder of the year.

3. Horizon Pharma, Inc. (HZNP). Horizon Pharma develops and commercializes medicines for the treatment of arthritis, pain, and inflammatory diseases. Horizon received FDA approval for Duexis on April 23, 2011, and for Rayos (Prednisone) on July 26, 2012. Duexis targets patients with symptoms of rheumatoid arthritis and osteoarthritis, whereas RAYOS is designed for a broad array of conditions, including rheumatoid arthritis, polymyalgia rheumatica, psoriatic arthritis, ankylosing spondylitis, asthma, and chronic obstructive pulmonary disease. Some authors have recently suggested that the market value of Rayos stands at around $1 billion a year, and JMP Securities gave the stock a price target of $16.00.

Despite these optimistic valuations, the company's stock is presently down a stunning 72% year over year, and has fallen 34% in the last month alone. Even more surprising is the fact that the stock has moved significantly lower in the absence of negative news and strong insider buying. To my mind, the only plausible explanation for the recent downward trend in HZNP's PPS is the January effect. Simply put, money managers are cycling this underperforming stock out of their portfolios for year-end. That said, I would expect HZNP to come roaring back to $3-plus in January as the company has too many positives going into the new year, and is therefore undervalued at $2.12 a share. Based on valuation alone, HZNP looks like a strong buy at these deflated levels and should be a nice long-term gainer in the coming years. For short-term traders, the January effect should give HZNP a nice move to the upside from the current levels.

Source: The January Effect And 3 Biopharma Stocks