REMEMBER THAT PLANE ride when the woman next to you was consumed with the Times crossword puzzle? Every so often, she would grimace in frustration and rapidly tap the pencil against her forehead. But after a few deliberate sips of red wine, she returned to her obsession.
I have my own fetish. It’s called the January effect.
As December winds down, the tendency of stocks to rise in January becomes a favorite topic of market pundits. It has bedeviled the best and brightest ever since investment banker Sidney Wachtel stumbled on the phenomenon some 80 years ago. In subsequent years, many academic studies have pinpointed small-capitalization stocks as the primary beneficiary of this seasonal anomaly.
So, what’s going on? Testifying to its elusiveness, many hypotheses have been advanced to explain the outperformance of small companies in January. By far the most popular of these is tax-loss selling. Investors take their losses in late December, driving down share prices, and then presumably buy the stocks back early in the new year.
Another theory implicates window-dressing. Large institutions dump their losers at year-end, so they won’t appear in their annual reports, and then repurchase the shares after Dec. 31. Others have pointed to a “bonus bump,” whereby corporate heavy hitters commit their year-end bonuses to buying stocks in January. Other commentators have proposed a sentimentality factor—that investors, in good cheer in the aftermath of the holidays, throw money into the stock market.
If January has historically been one of the best months of the calendar year, why has it been particularly good for small-company stocks? According to the venerable efficient market hypothesis, small stocks’ sensitivity to this seasonal anomaly is rooted in their greater volatility and risk. Thanks to the wide bid-ask spreads and low trading volume of small-cap stocks, the December lows tend to be that much lower and the January recovery that much sharper, especially when you have institutional investors throwing their dollars around.
As commentators have noted, the January effect has weakened in recent years. Perhaps the burgeoning growth of retirement assets has reduced the need for tax-loss selling. Alternatively, maybe the fear-of-missing-out crowd is buying early, shifting the aberration into late December.
Burton Malkiel, one of the esteemed fathers of the efficient market hypothesis and author of the iconic A Random Walk Down Wall Street, thought that calendar anomalies were doomed to extinction as more investors become familiar with them. Malkiel has also suggested that whatever calendar effects still exist aren’t big enough to justify the transactions costs involved in trying to exploit them.
Why am I boring you with all these details? Come December, I once again surrendered to my weakness for the small-cap anomaly and reached for Jeffrey Hirsch’s Stock Trader’s Almanac. The implication of the Almanac’s graph is clear: In recent years, the thrust of the small-cap bounce started around Dec. 15 and lasted through Jan. 15.
On cue, I bought $30,000 of the Vanguard Small-Cap ETF (symbol: VB) in mid-December. As you might gather, my recovery from addiction is not complete. Still, I indulge only in moderation, with more than 95% of my portfolio invested in broad market index funds.
You may be surprised at the outcome of my little experiment. Small stocks did indeed impressively outpace their larger fare. But my execution, alas, was fatal. You see, this go-round, all the outperformance occurred in January. In fact, the last two weeks of December actually showed a small loss.
So what, you say, you must have caught the January part of that move? But I didn’t. Frustrated and humiliated by the absence of any superiority among small companies in the final two weeks of 2022, I could stomach no more pain. I broke with my plan and liquidated my position on the last trading day of the year. So much, I mused, for any last vestige of the January effect.
I tell myself I’m not a momentum investor, but isn’t that what the recency bias of selling after the disappointing December was all about? Once again, I have to confront my old nemesis, emotionally driven trading that derails careful planning.
In the end, we had a rip-roaring small-cap rally, all in January, none in December. Here are the numbers. From Dec. 15 through year-end, Vanguard Small-Cap ETF lost 3.2%, versus a loss of 3.8% for Vanguard Large-Cap ETF (VV). Because of an outsized jump in small stocks in early January, the respective figures from mid-month to mid-month swung decisively in favor of small-capitalization stocks, with a gain of 3.2% for Vanguard Small-Cap compared with no change for Vanguard Large-Cap.
The small-cap effect over the entire month of January came in at an eye-popping 10.1%, versus 6.5% for large-caps, according to data from Yahoo Finance. Vanguard Small-Cap even outran the blistering 9.7% monthly return for Vanguard’s Information Technology ETF (VGT), heralding the best January showing for Vanguard Small-Cap ETF since its inception in 2004. Pronouncements of the demise of the January effect may have been premature. It is, it seems, still very much alive.
Knowing when to trade is doubly difficult. You have to be right on the way out as well as on the way in, and I failed that test.
More composed investors will heed this admonition from The Motley Fool: “You may end up with a winning set of stocks in the short run, but you may also disturb your asset allocation and spend a lot of time and energy doing so. A buy-and-hold strategy aimed at long-term investment goals is likely to be your best bet, so be careful when it comes to short-term calendar-based predictions.”
But I’ll give the last word to Forbes: “Small cap stocks can outperform their larger counterparts in January. But that doesn’t mean they always do.”
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.