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“WE GOT A THING going on, we both know that it’s wrong, but it’s much too strong to let it go now” are blues lyrics about a man and his lover. But they might as well be referring to my affair with the January effect.
Last year, I wrote about my favorite seasonal anomaly, the tendency for small-cap stocks to outperform large stocks during the first month of the year. In December 2022, I’d set out to see if the phenomenon was still alive. After analyzing market data from December and January, I concluded it was still on the loose, but might not be dependable.
At the start of many years, small-cap stocks appear to have the wind at their back. The hypothesis most often advanced: What we’re seeing is year-end tax-loss selling followed by the subsequent purchase of stocks believed to have been driven below their fundamental value. But how strong a force can this be when tax-advantaged accounts are now so large?
January’s small-cap performance has also been attributed to window dressing by money managers, who dump poorly performing stocks at year-end, so these holdings don’t appear in their next fund report. But wait a minute. Wouldn’t those large financial institutions be more likely to replace those small-cap shares with safer and more liquid large-cap stocks, thus spurring returns among these larger companies?
Many observers have also noted the possible role played by new money. Corporate bonuses need a home, and 401(k)s and IRAs require funding. And, as the new year begins, don’t ignore the potential boost from feelings of good cheer.
I imagine all this rigmarole is blasphemy to most HumbleDollar loyalists. Index fund investing is now regarded as the no-brainer choice for independent thinkers looking to build a retirement nest egg. Still, I think we have a few market junkies lurking out there.
In anticipation of testing the January effect’s reliability again this winter, I checked to see if any significant insights had been published over the past year. Indeed, they had. Buckingham Strategic Wealth Chief Research Officer Larry Swedroe, a relentless proponent of index fund investing, published a brief but definitive article on The Evidence-Based Investor website. His analysis goes way beyond previous efforts and, frankly, makes my earlier back-of-the-envelope attempt look like a junior high school project.
Swedroe threw two formerly underappreciated factors into the mix. He looked at whether small stocks outperform large stocks in other months, in addition to January, and whether trading costs like the bid-ask spread might nullify any attempt to exploit the anomaly. To spot any change in the January effect’s strength, he repeated his analysis over different time periods. His findings:
Seasonal anomalies like “sell in May and go away” are an anathema to proponents of the efficient-market hypothesis. The January effect’s persistence has been a thorn in the side of believers for 50 years. If the market is truly efficient, any recurring edge should gradually be smoothed out as the public catches on. Swedroe’s results show that’s exactly what’s happened with the January effect.
I don’t know whether to be in grief over my lost love or relieved I can let go of my obsession. Still, reality is never a complete cure. For however many Januarys I have left, I’ll be checking the performance of the Russell 2000 small-cap index vs. the S&P 500. But for now, my seasonal affective disorder is in remission. Same time next year?
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.
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You mention this information might appeal less to index investors. I think it would still be interesting to them. I recently joined an account where I didn’t have the full complement of index funds I would have liked and ended up putting part of my investments in a Russell 2000 fund, of all things.
Glad the article was helpful to you. Don’t worry about your small caps in January. They appear to be cheaper than large caps, so the fund might prove a good complement to your others over the long-term.
Loosely reminds me of the Presidential Election Cycle Theory where equity returns peak in the third year. Witness the runup toward the end of 2023. Unfortunate those who remain fully invested in a well diversified portfolio can’t take advantage of this unless presented with new money in years one and two.
Hi Klaatu,
I agree—for the most part. Historically, the market does seem to get a boost during the third year of a President’s term, presumably because he is busy juicing the economy in anticipation of the next election. But if that’s the theory, why isn’t the final year the best as the economy benefits from the goosing? And the first two years have not done as poorly as Yale Hirsh had predicted many years ago in his Stock Trader’s Almanac. The efficient market hypothesis may need to come to terms with this apparent anomaly, but remember there are only a relatively small number of cycles and so very few data points from which to draw a conclusion. Apart from that, there is as you say the problem of how fully invested people can exploit the effect. One possibility is to increase the volatility of the portfolio for the third quarter, but then you would probably be overexposed to growth stocks and particularly in technology. All in all, you raise an interest question.
Steve, my life is also attuned to the seasons. January is a great month—two packages of seeds arrived today! And I expect the same will happen next year.
Hi Edmund,
You are indeed fortunate for the constancy of seeds. Please have compassion for those of us who have traveled with the unpredictability of the markets……..
Steve
Ah, but there are the vagaries of the weather, and so. More seriously, thanks for highlighting Swedroe’s research.
Hi again,
I guess all of us are susceptible to randomness. Yes, I’ve followed Larry Swedroe’s work for many years. He is a top-drawer researcher and commentator.
I know only too well. But if I use it, will I be satisfied with not beating the S&P?!
Lamps work wonders for seasonal depression 🫥
Whoops! Please see response above.