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Jury is out on Playing the January Effect
Short-Term Market Swings Are Difficult to Predict
Around this time each year, investment managers decide whether to use trading strategies that seek to take advantage of the January Effect, the name given to the phenomenon that may occur when tax-conscious investors sell stocks that are down for the year in order to write off losses against capital gains. The sell-off of losers sometimes causes stock values to go down near the end of the year but back up in January when investors return to buying.
In years that this effect has been visible, small-cap stocks have often outperformed large-cap stocks in the beginning of the year. Over the past 13 years in the US equity market, small stocks, as measured by the Russell 2000® Index, have gained in January more strongly than large-cap stocks, as measured by the Russell 1000® Index, six times. For example, in January 1991 the Russell 1000 gained 4.5%, whereas the Russell 2000, rose 8.9%. In 2001, the Russell 1000 was ahead 3.3% whereas the Russell 2000 added 5.2%.
Some investment managers decide against playing the January Effect. Usually their reason is that it is a short-term strategy and most hold stocks for a longer term. Even if it works, they say, they are not sure that it is worthwhile trying to play it.
Another reason, some managers argue, is that the January Effect is unpredictable. Not only can they not be sure whether the January Effect will occur in any particular year, they do not know how much of a move it will be if it does take place. They agree that in some years small-cap stocks do show stronger gains than large-cap stocks in January, but in other years they do not do so.
Many managers conclude that no one can reliably predict whether small-caps will rise more than large caps in any month let alone in January. Also, they argue, if anything, the pattern is likely to disappear if everyone plays it because that is the nature of markets.
In short, to these managers the risk is too great to hope the January Effect will occur.
Watching for Clues
Others argue that in some years it has paid to play the January Effect. They agree that the Effect has not worked every year, but they suggest that a careful examination of the markets in the year leading up to January indicates why it has worked in certain years and not in others.
Historically, they argue, if a number of stocks have been weaker performers during the prior year they have been under pressure toward the end of the year as investors with taxable portfolios sell their losers. Other investors then buy into these oversold stocks in January, once the source of selling in December was removed, and the stocks recovered.
These managers conclude that many of the best performing stocks in January have been those that were badly hit the year before and whose values were depressed.
Taxing Influences
On the other hand, particularly when small-cap stocks have performed well, potential sellers defer their sales until January to avoid having to pay capital gains for the previous financial year. Simply by waiting to sell until early January, they delay paying capital gains taxes for another 12 months.
Such action in the past has impacted the January Effect and in those years January has seen selling rather than buying.
Therefore, the argument goes, following a year in which small-cap stocks have underperformed the January Effect has played itself out. Following a year of good small-cap stock performance, however, it has been unlikely to do so. Proponents of this theory point out that during the past several years small-cap stocks have performed well and the January Effect has been muted.
Large caps have outperformed small in 2005. Through Dec. 19, the large-cap Russell 1000 was up 7.03% year to date. The small-cap Russell 2000 had gained 4.32%. These indexes are benchmarks and cannot be invested in directly.
Some analysts suggest that historically those traders who believe in the January Effect have been buying stocks earlier to try to take advantage of it. The result has been that stocks have risen during that time, leading to the January Effect making itself felt in December and even in November.
NOTE: Fund objectives, risks, charges and expenses should be carefully considered before investing. A prospectus containing this and other important information can be obtained by visiting the mutual funds section of Russell.com. Please read the prospectus carefully before investing.
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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