The January "Defect"

12/30/2005 12:00 am EST

Focus:

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Is the well-known January Effect–in which small-cap stocks rise sharply at the start of the year–a reality or a myth? According to Dan Wiener, "This ‘effect’ is really a ‘defect’ and the numbers don’t support the theory." Here, along with Abby Joseph Cohen, he explains.

"It’s that time of year again when the pundits are telling you that small-cap stocks will rise in January. How do they know? Well, it’s the famous ‘January Effect,' something which I’ve taken to calling the ‘January Defect.’ Like the tooth fairy, the January Effect, which claims that small-cap stocks experience strong returns relative to the market every January, is a myth. Maybe it’s the eggnog, but I guess someone forgot to do the math—over the last two decades those who tried to capitalize on this ‘trend’ have pretty much been out of luck.

"But here’s the explanation you’ll probably hear: Investors engage in tax-loss selling towards the end of the year, depressing prices. Small-caps are most affected by this because of lower liquidity or because they are shed by portfolio managers at year-end trying to ‘window dress’ their funds before their reporting periods end by getting rid of lesser-known names. It’s those same small-caps that allegedly experience the bigger bounce once folks start buying again in the new year.

Cohen, Abby Joseph"But as this supposed trend gained notoriety and popularity, investors began trying to front-run it, buying earlier and earlier to beat the crowds, causing the January Effect to shift into November or December (assuming it exists at all). My friend Abby Cohen (click on her photo at left for more information), Goldman Sachs’ chief investment strategist, concurs. She thinks the January Effect is more of a rebounding rise in stocks of all shapes and sizes, and that it begins in November, once many mutual funds have closed out their fiscal years and taken whatever capital gains and losses they have for tax purposes. Also, she says, year-end bonuses thrown into the market also provide a lift for prices.

"Abby’s got a point. Look at the actual numbers. While the January Effect is questionable at best, we can compare this to the performance of SmallCap Index versus S&P 500 Index in November and December. The 15-year average gain for the SmallCap Index shows a 2.6% rise in November and a 4.1% gain in December. The rise in January is 1.7%. My preference has never been to look for short-term gimmicks as a means of achieving market outperformance, but rather, to plan for the long-term. Overall, on average, over the past five, ten, and 15 years, November and December have been the months when small has beaten large. Not January."

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