Trading the January Effect

12/14/2012 8:30 am EST


Jeffrey Hirsch

Editor-in-Chief, The Stock Trader's Almanac and Almanac Investor

Jeffrey Hirsch explains the strategy that he uses to trade the so-called "January effect."

My guest today is Jeffrey Hirsch. He is the expert on seasonal trading with Stock Trader’s Almanac. We’re going to talk about the January effect and what that means to traders and investors. So, Jeffrey talk about what is this January effect?

Well, just to clarify we also have something called the January barometer. The difference is, the January barometer is the indicator of the how the year goes, based upon how the S&P goes in January. As the S&P goes in January, so goes the year.

The January effect is the tendency for stocks in general, and especially small-caps, to outperform large-caps in the month of January. What our researchers found over the years is that it has shifted towards the middle of December; most of the so-called January effect now takes place in the middle of December.

We take the Russell 2000 and extra small-cap stocks over the Russell Index and 1,000 large-cap stocks and you see this wonderful picture where you have the line going down throughout the year, and then in October it starts at the bottom and you get a little bounce in November, and then in mid-December it takes off in small starts, outpacing large-cap stocks through March. It’s worthwhile for investors and traders.

What is the trade? Is it just going along the Russell 2000?

That’s one way. There are options trades you can use. We have an interesting take on it. We call it the only free lunch on Wall’s just a cute name as a reminder. Or we pick up bargain stocks hitting new lows in late December.

It used to be in mid-December to mid-February, things seem to have shifted where tax selling tends to go a little bit further into the end of the month. And we find that doing it on the triple witching day, the third Friday in December, you get a lot of action and a lot of volatility with all the options and futures expiring. It also gives us the weekend to sift through any real dogs, any glaring issues.

So what we do is we take new lows on the third Friday of December on the New York Stock Exchange, American Stock Exchange, and Nasdaq, and we only take the ones that are down the most depending upon how many years they are. Sometimes you’ll get 100. Sometimes you’ll get five.

You get rid of preferreds, new issues, splits, special dividends, anything that hasn’t been trading for more than a year and isn’t just a regular common stock. That’s outpaced the New York composite by about 9.5% over the period back to 1968.

What we do now is we recommend a different strategy to our subscribers in the newsletter when we see things happening. It’s a real quick strategy only for sophisticated traders, people who can move quickly that are nimble. You don’t fall in love with these stocks—they can be real dogs—and if you get a quick pop, you get out.

So what is the rationale behind this? I know all seasonal traits have something that is behind it that forces that to happen. What do you think it is for small-caps?

Well, I think this January effect is really created by tax-loss selling. Small-caps get dumped the most and they get knocked down.

And then there is this general bias of buying. You know a lot of people leave the Street. There’s the Santa Claus rally that has stocks moving up the end of the year. A lot of retail investors are away doing things, holiday parties, and there are a lot of professionals gobbling up these beaten-down stocks for the popping. You could jump on that ride.

Alright, in terms of buying those ones that are at 52-week lows, do you take a look at why they’re low and discount some that may have bad news or bad earnings for some reason?

Yes. That’s why we do it on that third Friday, because it gives us that weekend to check a couple things, and we also don’t want to pick ones that are really thinly traded. We want some volume. We don’t want people getting beat up and getting into something you can’t get out of.

So we look for some issues. We’ll glean the news headlines and look for anything glaring, and make sure that the stocks are just down from basic selling. If there is a big gap in the chart or something goes on, we’ll take a look at it. So we’ll go through these things one by one and pick out anything that’s really a bad situation.

Related Reading:

A Special Dividend Trend

The Real Indicator to Watch

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