Hey, Who Stole My January Effect?

If you were counting on the January Effect to generate easy profits this year, you were sorely disappointed.  The January Effect showed up in full force this year... only it arrived one month early, stealing the benefit of the popular anecdotal "Effect."

In general, the January Effect refers to the tendency (or expectancy) for Small Cap stocks - usually those that are part of the Russell 2000 Index - to outperform Large Cap stocks - usually those in the Dow Jones 30 or S&P 500 - on a relative basis during the month of January each year.

Reasons include tax sheltering, portfolio shifting, and the volatility of smaller capitalized stocks.

Tax sheltering refers to  portfolio managers and investors tend selling poorly performing stocks in December at the end of the year to lock in losses, which helps offset some of the gains in other stocks in their portfolio to reduce taxes.

Generally, these same people who sell underperforming stocks at the end of the year turn right around and buy other stocks early in January to set up or adjust their portfolio for the year.

Because smaller cap stocks are more volatile than larger cap stocks, they tend to fall harder in December and then recover quicker - when investors begin buying - in January.

Such is the logic of the mysterious January Effect, but in reality, the effect is being discounted by the market, such that Small Cap stocks rally earlier than expected, which was exactly the case this year.  It's an example of how popular Wall Street Lore gets discounted by the market, making it roughly ineffective if applied as defined.

It's like the saying "If the world knows that a stock at $25 will rally to $27 tomorrow, it will rally to $27 today."  It's just one more example of the market 'outsmarting' the general public who relies on commonly distributed market wisdom. 

Still, let's take a look at how small cap stocks - as measured by the Russell 2000 index performed when compared to their larger cap cousins, as measured by the S&P 500.  We can also learn a lesson in how to assess relative strength of markets.

The chart above shows the relative performance of the Russell 2000 (small cap stocks) to the S&P 500 (generally large cap stocks).

Think of this chart, which you can recreate in StockCharts by typing in "$RUT:$SPX" as a division function, where the first index - Russell 2000 - is the numerator and the second index - S&P 500 - is the denominator.

When the numerator rises, the line will rise.  When the denominator falls, the line will rise.

When the numerator falls, the line will fall and when the denominator rises, the line will fall.

A rising line means that small cap stocks are outperforming on a relative basis the large cap stocks, while a declining line means that small cap stocks are underperforming on a relative basis the large cap index.

This type of logic works well when comparing individual stocks to their benchmark index (such as "GOOG:$NASDAQ") or other stocks to each other (such as "KO:PEP" which compares Coca-Cola to Pepsi).

It's best to use line charts and only use simple trendlines when looking at relative strength stocks, as shown above.

A break in an established trendline means the relationship is changing, as highlighted by the arrows.

There's an interesting quirk to relative strength charts, and it's in the sense that both components can be falling, but one can be falling slower than the other, which means the line will rise even when both securities are falling... or can fall when the numerator is not rising as quickly as the denominator.

Notice that the relationship broke the trendline in early December and then rallied sharply into January... that's the January Effect coming a month early.

What happened in January? 

The relationship stayed stable, so while the market itself rose and fell in the month of January, the relative performance of the Small Caps to the Large Caps were roughly equal or trendless.  In other words, there was not much change in the relationship, meaning the January Effect did not occur as expected (we would expect the line to rise for all of January as it did in December).

We actually saw a downside trendline break in early January, hinting in a change in the relationship. 

Now, the Russell 2000 is falling faster than the S&P 500, revealing the volatile nature of small cap stocks (falling harder in a decline than the more stable large caps stocks).

Study these relationships closer and see if you would benefit from adding relative strength charting analysis to your investment or trading style.

Corey Rosenbloom, CMT
Afraid to Trade.com
http://blog.afraidtotrade.com

The January Effect was first observed in the early 1980s by Donald Keim who, at the time, was a graduate student at the University of Chicago. It is the observed phenomenon that since 1925, small stocks have outperformed the broader market in the month of January, with most of the disparity occurring before the middle of the month.^[1]

The most common theory explaining this phenomenon is that individual investors, who are income tax-sensitive and who disproportionately hold small stocks, sell stocks for tax reasons at year end (such as to claim a capital loss) and reinvest after the first of the year. The January effect does not always materialize; for example, small stocks underperformed large stocks in January 1982, 1987, 1989, 1990, and 2008.^[2]