The January Effect - For Traders Only

12/20/2002 12:00 am EST

Focus:

"January," according to French author Colette, is "the month of empty pockets."  While consumers do often face the new year with depleted levels of cash, stock market traders, however, may see an opportunity for short-term gains.  Here, we look at two trends for short-term traders--the historical outperformance of small-cap stocks over large caps in the late December to early January period, as well as the case for a rally during the same time frame.

Larry McMillan "This is the time of the the year when we get to trade the January Effect," says Larry McMillan, editor of The Option Strategist. "The January Effect is something that we have traded often and quite profitably over the 11 years that we’ve been publishing. Historically, the January Effect is defined as the seasonal inclination for small-cap stocks to outperform large-cap stocks. For many years, this effect had occurred during the month of January, so that is where it got its name. The effect usually begins much sooner than January these days, but the name has stuck. The rationale behind this effect is that small-cap stocks are beaten down by year-end tax selling. Once that ends, they spring back faster than their big-cap brethren. This is true whether the overall market is going up or down. So, to take advantage of this phenomenon, one would buy the small-caps and sell the big-caps as a spread transaction. Then, when the small caps outperform, the spread should widen regardless of the direction of the broad market averages.

"Since the strategy has a profitable history, it is worth trying to work it into one’s arsenal of seasonal trades. By the way, notice that the proper definition of the January Effect does not say that the market will rise in January, even though some unknowledgeable commentators say so. The January effect simply expects small caps to outperform large caps. For trading purposes, traders can use futures, options, underlying indicies, or exchange-traded funds to trade the spread between small-cap and large-cap stocks, without betting on a specific upmove or downmove by stocks. Finally, it must be understood that no one year necessarily conforms to the composite chart. Each year has its own characteristics. But history gives us a general idea of how to trade this January Effect and, more importantly, when to trade it. The normal January effect actually starts in late December, on average, and has pretty much run its course by the first few trading days of the new year. To be specific, the effect actually begins 55 days after the end of September, which this year places it on Monday, December 23rd. The end of the January effect occurs 12 trading days later, which this year would be on Friday, January 10th. Finally, we would note that the overall weight of the evidence has turned bearish, despite the fact that there may be some seasonal bullishness over the holidays. We also note that the Santa Claus rally does not always occur, and when it doesn't, things can get quite bearish. Remember the slogan, 'If Santa Claus should fail to call, bears will come to Broad & Wall'."

Elliott Gue Says Elliott Gue, editor of Wall Street Winners, "Short-term, there are plenty of reasons to expect a rally into year’s end. First and foremost, the run-up to Christmas and into the New Year is a seasonally strong period for stocks. In fact, based on the action of the Dow since 1915, November and December are the market’s two strongest months and show a rally about 70% of the time. What’s more, the last two weeks of the year are almost never losers; about 80% of the time we’ve seen a rally in the Dow during this period. We’re just about to enter that seasonal sweet spot. And remember that most fund managers have had a terrible 2002. After all, the S&P 500 is still down about 20% year-to-date despite all the hoopla surrounding this recent rally. Those managers are looking to spruce up their returns ahead of year end; their jobs and year-end bonuses may hang in the balance. The result has been that we’ve seen fund managers chasing the most volatile stocks higher since the October bottom simply because that’s the fastest way to make up a few extra percentage points in performance by the end of the year. These same managers will be desperately trying to keep this game going into year-end.

"So what’s the most likely outcome? We’re likely to see one more shot at a rally. It wouldn’t be at all surprising to see that rally make a marginal new high somewhere in the 965 to 985 region for the S&P 500 between late December and mid-January. To trade this move, we’ll be looking to play the long side of this market during the next few weeks. Caution, however, is key in this environment as a break below 890 to 892 on the S&P would pave the way for a move back to 875 in short order." For those who are fully aware of the speculative nature of options, Elliott Gue suggests that traders consider the Semiconductor HOLDRs; he recommends the February SMH call options (strike 25). He also likes Diamonds, which replicate the Dow. He recommends the January DIA calls (strike 86). 

Happy trading and happy holidays!

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