The January Effect: Will It Hold In The Current Investment Climate?

As we head into 2012, there are a multitude of scenarios that may unfold. But looking at the short-term, some investors look forward to this time of the year because of the January Effect, an apparent anomaly that questions the efficient market hypothesis.

The January Effect is named for the fact that monthly performance in January has been overwhelming positive. This has primarily been attributed to large stock sell-offs in December for tax purposes, thus resulting in appreciation when investors flock in to buy stock in the New Year. That’s the logic at least.

Furthermore, the effect has been said to have a more pronounced effect on small cap stocks, which arguably are more susceptible to mispricing during periods of significant selling and buying that can benefit investors. For example, since 1926, small caps have outperformed large caps in January over 70% of the time.

However, the effect hasn’t held up so well lately in the wake of the financial crisis. And as investors catch onto this “inefficiency,” especially once you add high frequency traders into the mix, reaping the benefits becomes increasingly difficult since there are more market participants aware of the effect. Trying to guess where that window of opportunity will arrive is a fruitless, treacherous endeavor.

From 1951 to 2011, the S&P 500 had a positive return in January roughly 63% of the time. However, one can see below that as of late, the index has had some rough starts to the year.

Already, the signs don’t look promising. Equity mutual funds saw $135 billion in outflows in 2011.

Nevertheless, there are possibly some small Cap ETFs that may outperform the broad based index if underlying reasoning behind small cap outperformance holds true. Though these types of strategies may be tempting, they don’t fall in line with my investment philosophy. And I would advise others not to do the same, especially once transaction costs and tax implications are taken into effect.

I am certainly not in a position to speculate on a theory, especially with the vacillating nature of markets that we’ve seen in the last several months. Despite literature suggesting an advantage in January, we can’t use the past as an accurate indicator for current market behavior, which represents a unique set of circumstances.

Seeing as contagion effects from Europe have negatively impacted global markets and will likely continue to do so, I prefer to stick to a low risk, bond/sector ETF driven strategy for now rather than try to capitalize on an apparent anomaly. Hindsight’s always 20/20 and costless, but misguided foresight can leave a nasty financial scar.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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