12-28-2009

Is the January Effect Suspended for 2010 or Will a Different January Effect Emerge?

The January effect has morphed over time.  Knowledge of this market anomaly has even led to the January effect being a December effect in some years.  This year, however, we will either have no January effect or a new January effect may emerge. 

“The January Effect is a calendar-related anomaly in financial markets where financial securities prices increase in the month of January.  This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.”[i]

The theoretical explanation of the January effect, and its corollary small-cap outperformance observation, is that retail investors who are tax-sensitive choose to take capital losses during the month of December, and then after the 30-day wash rule waiting period, buy the stocks back in January.  Further interpretation suggests that the selling pressure on small stocks from tax selling creates buying opportunities in these “sold off” stocks that is taken advantage of in January.  In any event, over the last 85 years, most years do record a first-half January outperformance of small cap stocks.

This year, there have been no losses that people either have or wanted to take in December.  Most taxable investors took losses last December.  This year, only those that have held stocks through the market cycle still have losses to take.  Those long term investors are most likely heartened by the performance of their stocks since March, and therefore, probably will not sell them to take significantly smaller losses than they had on paper a year ago.  People who bought stocks during 2009 have few losses to take, in general. 

There are, however, lots of investors who have short term gains.  This is the group that is torn.  They fear a correction, but their greed is not fully fulfilled yet.  The first wave of these trader/investors will have long term capital gains in April and May.  They may want to wait until then to sell.  However, if they see a big correction start they may want to sell early next year to lock in profits that they won’t pay tax on until April of 2011.  The real question is whether buyers and sellers, in aggregate, foresee enough economic challenges coming to warrant selling early next year.  Will this group start a correction early in 2010, or will the continued march of a self-sustaining economic recovery keep them locked into stocks as they recognize that we are still very early in a new market cycle?

Over the last year, we’ve pointed out several times that what we are seeing in the market today is describing the headlines that will be printed 6 to 9 months from now.  The stock market correctly discounted the better-than-expected economic and profit results that posted in the fourth quarter as early as April, and continued to prognosticate better things for the balance of the year.  The question now is whether stocks are at a level that discounts a better-than-can-be-delivered next six to nine months.  The market’s participants acting in concert will deliver the answer to that question early next year.  It could go either way, and we’ll be watching for the answer. 

The two things that we know that would spook the stock market are either a spike in the ten-year bond yield, or a terrorist event of consequence here or in the Middle East.  Even if, God forbid, the worst of these happened, we would not be looking for an opportunity to get out in front of a correction. 

We still are dedicated to three steadfast rules of rebuilding your net-worth that we have now been chanting for six months.  We believe that those that follow these rules will look back in five years with great satisfaction at their decisions. 

1.      Don’t sell into corrections, buy more when they happen.

2.      Start investing in stocks in International Stock Markets. 

3.      Keep bond maturities short. 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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