It Is Time to Prepare for the January Effect

Some things happen with regularity. Old Faithful erupting. Congress changing tax laws. New York Yankees owner George Steinbrenner firing managers.

And you can almost always count on the January effect.

That is the tendency of small-company stocks to outperform big-company stocks in January, due largely to year-end moves by institutional investors. Investors who buy small stocks in late-December and sell in mid-January often do well.

The effect works 80% to 90% of the time, contends Robert A. Haugen, finance professor at UC Irvine and author of a book on the effect.

Between Dec. 31 and Jan. 15, for example, the small-stock-oriented American Stock Exchange market value index outperformed the big-stock-oriented Standard & Poor’s 500 index in each of the past seven years, Haugen says. Last year, the difference was about 3 percentage points, he says.

In the 37 years between 1953 and 1989, Standard & Poor’s low-priced stock index (small stocks often are low-priced) beat the S&P; 500 in 35 of those years, notes Yale Hirsch, publisher of the Stock Trader’s Almanac and a market historian.

“The January effect is immense,” Hirsch says.

Several factors produce the January effect. The main one is the fact that institutional money managers--those pros who manage pension funds, insurance company funds and other big investment pools--are rewarded for beating the S&P; 500. As year-end approaches, money managers seek to lock in their gains compared to the S&P; by selling off small stocks and buying big stocks. That depresses small-stock prices.

Then, when the new year begins, they buy small stocks that they think will outperform the S&P; 500. This massive buying boosts all stocks, but small ones in particular (because if you buy big stocks, you will only match the S&P; 500).

In fact, studies have shown that most of the gains in the market for the entire year come usually in January--particularly the first two weeks. Without January, stocks on average perform only slightly better than Treasury bills, Haugen says.

Stocks, both large and small, also tend to take off in early January because institutional money managers want to be fully invested in stocks starting off a new year, for fear that large cash holdings may leave them trailing the market averages and thus off to a bad start for the year, suggests John A. Connolly, chief investment strategist at Dean Witter Reynolds.

But playing the January effect is no sure thing.

For one, you might not time it right. You run the risk of getting in, or getting out, too early or too late. As more investors have learned of the January effect, they are trying to get a quicker jump on it. That has pushed the start of the effect into mid-December. Who knows? This year it might even start in late November.

For another, you still could lose money if both small and large stocks go down. That has happened several times in recent years. The January effect doesn’t guarantee that you will make money if the market as a whole tumbles--you simply will lose less in small stocks.

One clue to gauge whether the January effect might occur this time around is to look at whether small stocks decline between now and mid-December. A larger decline--possibly indicating that institutions are dumping--increases the chances of a strong January effect, Hirsch argues.

“If stocks are god-awful now, I’d be very bullish,” he says. “But if it’s bullish now, I’d be bearish (later).”

Haugen argues that the evidence for a strong January effect is already in. The Friday the 13th mini-crash last month prompted many money managers to dump small stocks and go into safer blue chips, he says. These managers will be poised to jump back into small stocks in January, he says.

How can you play the January effect? Sophisticated investors with big bucks can build their own portfolio, looking for real dogs: stocks that pay no dividends, stocks that have performed poorly in the last five years, stocks that have low prices, even junk bonds (yes, they also have a January effect).

But be careful, because not all small stocks will participate in the effect. “It’s hard to quantify which stocks you should buy,” Hirsch says.

Because it’s hard to pick the right group of small stocks, most amateur investors should play the January effect through no-load (no sales charge) mutual funds specializing in small-company stocks. Pick funds that are part of large fund families with money market funds. Then you can switch from the money fund into the stock fund, and switch back out, quickly and easily.