Tuesday, December 26, 2006

January Effect: Fact or Fantasy

One of those “calendar anomalies” is close upon us - the so-called January Effect - wherein the market dips at the end of December as investors take losses for tax purposes and then rises in the first weeks of January as investors re-invest the excess cash. (InvestorWords provides a good explanation of how it is observed.)

Unlike some market trends or cycles that seem to occur with as predictability as the calendar pages turn, the January Effect has been waning in significance.
There may be a couple of reasons for this. One is that individual investors have become savvier in recent years, plowing more of their assets into tax sheltered accounts. In these accounts, year-end stock sales have no value for tax purposes. Second, the market seems to do a better job of anticipating this potential calendar effect and stock prices are often adjusted well ahead of the end of December.

This year is not likely to be any different. Indeed, there may be far less tax loss selling this year than in times past. Most of the indices will close ahead for the year. That is not to say that there will be no incentive to hide some capital gains by taking losses on other stocks at the year-end. However, strong market performance in 2006 may encourage some investors to hang on to the laggards in hopes of recovery in the future rather than realizing losses.

Even if there has been some late December selling to generate tax losses, it is a bit murky on how to capitalize on it in January. Highly populated as it is by early stage companies, the small-cap sector appears to generate a disproportionate share of stocks that could be candidates for year-end tax loss selling. If you expect an infusion of capital in January, which stock will you buy in order to benefit from the January Effect? More than likely, sellers in December will flee to quality and that usually means mid- or large-caps.

Since the January Effect appears weak anyway, it might be better to use another calendar anomaly. See an earlier post in May 2006, “Sell in May and Go Away,” on the Halloween Effect, which was first observed in London market in the 1800s and remains significant on this side of the pond today.
MonkeyChimp, a financial education resource, provides a calculator to explore monthly market returns. See for yourself which calendar effects are most significant.

Neither Small Cap Copy nor Crystal Equity Research is affiliated in any way with the companies or services mentioned herein.

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