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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.