How to Play Seasonal Anomalies for Profit

By John Whitefoot

As all investors know, no two equities march to the same drum. This would then mean that, technically, it should be impossible to predict future returns based on readily available information. However, this might not be entirely true, as it turns out there may be something to be said for some seasonal investing patterns after all.

First off, when it comes to gathering statistics, there’s no better place to look than the stock markets. Monthly price data for equities on the New York Stock Exchange (NYSE) goes back to the early 1900s and data from the other indices goes back to their infancy. So it’s possible to gather objective data and weed out irregularities.

One of the most popular investing seasonal anomalies is the “January effect,” which really runs from late December to at least the end of February. The January effect theorizes that small-cap U.S. stocks have a history of outperforming the S&P 500.

Also Read: NYSE 2014–2016 Holidays Schedule

The January effect was first observed by investment banker Sidney B. Wachtel and published in his paper “Certain Observations on Seasonal Movements in Stock Prices,” which appeared in The Journal of Business of the University of Chicago in 1942. In his paper, Wachtel shows that since 1925, small-cap stocks have outperformed the broader market in the month of January. (Source: Wachtel, S.B., “Certain Observations on Seasonal Movements in Stock Prices,” The Journal of Business of the University of Chicago April 1942: 15 (2); 184–193.)

Why is this? Most analysts theorize that tax-loss selling ramps up near the end of the year, when investors sell losing positions. Larger stocks can absorb the hit—but smaller stocks, not so much, which makes them prime rebound candidates for the January effect. The January effect might also be subconsciously engineered, in part, by mutual fund managers who tend to get more conservative later in the year; focusing on larger stocks and turning their backs on smaller, riskier stocks.

Between 1957 and 2007, the average January return for an equally weighted portfolio of stocks tilted toward small-cap stocks was 5.3%, while the return for a portfolio weighted toward large-cap stocks was 2.2%—a sizeable difference. (Source: Athanassakos, G., “How to play the stock market’s January effect,” The Globe and Mail, December 30, 2013.)

According to other research, the Russell 2000 small-cap index outperforms the S&P 500 for a three-month period between December 15 and March 12. The Russell 2000, which was trading at 1,110 on Friday, December 13, 2013, gained during the December–March period in 19 of the last 25 years, for an average gain per period of 5.83%. During the same December–March period, the S&P 500 has climbed by an average of 3.25%—again, a sizeable difference. (Source: Vialoux, J. and Vialoux, D., “ETFs to buy as small-cap stocks enter seasonal high point,” The Globe and Mail, December 20, 2013.)

The U.S. economy might be an added bonus to the January effect this year. Not surprisingly, most small- and mid-caps are more focused on the domestic economy; as a result, earnings should pick up more than usual as the U.S. economy gains steam.

Normally, when a stock market trend is common knowledge, it loses its effectiveness. But, over the last 55 years, the January effect has been quite resilient. And even though we’ve already started the third week of January, there’s still plenty of time for investors to benefit from the January effect.

To capitalize on the January effect, some investors might favor looking at small-cap stocks that took an unjustified hit in December. Risk-adverse investors might want to consider small-cap exchange-traded funds (ETFs).

One of the most popular small-cap ETFs is iShares Russell 2000 IWM. Investors might also want to do some research on the Schwab U.S. Small-Cap ETF SCHA or even the iShares S&P/TSX SmallCap Index (TSX/XCS).

If you do want to look at individual small-cap stocks, just remember that the January effect isn’t 100% accurate. To protect yourself during the January effect, only consider those smaller stocks that are fundamentally solid.

This article How to Play Seasonal Anomalies for Profit was originally published at Daily Gains Letter