The January Effect and IWM

Observe the stock market long enough and you start to notice patterns on the calendar.  In fact, there is a whole category of “seasonality” trades that are based on tendencies for certain things to happen at certain times of the year.  None of them are perfect, but they work often enough to be part of many trading strategies. 

The January Effect in 2009?

One such pattern is called the “January Effect” or January Anomaly.  This effect relates to a historical phenomenon where stocks rise in the first week of January compared to the closing price of the previous year.  It seems to be caused by a couple of factors.  For one, investors seeking a tax loss at the end of the year will sometimes sell even though the market may not dictate such a trade.  Those same investors will then replace those positions at the first of the year to initiate a new trade.  This activity forces a bullish move in the equity markets in the first week of January.

Mark Hulbert talks about another reason researchers provide for the January Effect.  ”Because the January Effect appears to owe its existence in large part to investment managers’ increased appetite to invest in riskier stocks once the New Year begins…it has to do with the benchmark that managers must outperform in order to earn their year-end bonuses.”  In other words, some money managers are willing to game the system while trying to beat the benchmark – either by shedding risk at the end of the year or by taking on more risk at the beginning of the year to earn their bonuses.

Small Caps Win From the January Effect

One of the best places to bank on the January Effect is in small capitalization companies, or small caps.  Those same managers who are willing to take losses in the broad market at the end of the year are typically more likely to take risks in smaller stocks in the New Year.  The reason is there’s more room for upward movement in smaller stocks than in large caps.

The January Effect doesn’t work every time.  But there are other reasons why this trade may be a winner this year.  For instance, the market has taken a beating in 2008.  Since September, small caps alone have declined -34%.  We feel small caps are due for a modest bounce.  The Russell 2000 is in a short-term uptrend, having put in a series of higher lows since late November.    

To take advantage of the upcoming January Effect, go with Russell 2000 Index Fund (IWM).  This ETF tracks the smallest companies in the Russell 3000 Index.  There is a good chance for a positive move in the next few weeks. If you buy IWM now, look at it as a short-term trade, i.e. weeks not months.  Take your profits and look for the next move from your bag of tricks.

If you want to reduce your risk, try pairing IWM with a large-cap inverse ETF like Short S&P 500 ProShares (SH).  Invest an equal dollar amount in both, and you will capture the difference between large-cap and small-cap stocks.  You could make a profit even if both indexes go down, as long as small-cap does better than large-cap.