The Investment U E-Letter: Issue # 398
Wednesday, December 29, 2004

The January Effect: Another Wall Street Investment Scam
By Dr. Steve Sjuggerud, President, Investment U

“On the basis of history, the only profitable time to hold small stocks is the month of January.”
Jeremy Siegel, in the excellent book, Stocks for the Long Run

It’s true throughout history, small stocks HAD obliterated large stocks in January.

There is no comparison. From 1925 to 1993, small stocks beat large stocks in January in 69 of the 81 years.

Even more amazing, the return difference has been about FIVE percentage points (roughly, big stocks had returned 2% in January, and small stocks returned an astounding 7%).

On the surface, the January Effect appears like a promise of “free money” during that month - just buy on the last trading day in December and sell on the last day in January, and collect a 7% return. Because of this, the entire financial world alerts you to this January Effect on small stocks your broker, your magazines, CNBC, you name it. And therein lies the problem

Today we’ll take a brief look at why small stocks may have soared in the past in January. And then I’ll explain why I think the January Effect is now just another Wall Street investment scam - one that the financial world uses to get you to buy stocks, but in reality the fabled January Effect actually won’t ever be a reliable strategy again.

The January Effect and Why Stocks Soar during this Month

Why do small stocks rise by 6%-plus in January? Is there a logical reason for the January effect? It sure doesn’t seem to fit into the widely accepted “random walk” theory about stocks, where stock prices move like a blind drunk in a field, and therefore no month should be better than any other.

The reason for the January Effect is debated among academics. The most common explanation is for tax reasons Individual investors sell their small stocks that have declined in December to offset capitalgains taxes, and selling knocks down the prices.

There is some evidence for this, as there isn’t proof of a January effect before 1913, when taxes were introduced. And in Australia, where the tax year actually ends in June, stocks show a “July Effect.”

New money into the market is also believed to have played a part. The data shows there is an increase in public “buy” orders in the new year versus sell orders. Whatever the actual reason, there is no doubt that there at least WAS a January Effectuntil now.

Why the January Effect Is Now Dead

Psst let me let you in on a secret that Wall Street doesn’t seem to know. The January Effect is now dead-the simple reason being that once everyone on Wall Street knows something works, it won’t work anymore.

The January Effect was first discovered in the 1980s by Don Keim. Never heard of him? Neither had Wall Street. But by the early 1990s, everyone knew about Don Keim’s discovery of the January Effect. And once everyone knew it, it no longer worked, as this table shows

The January Effect Since 1994: Completely Worthless

• 1994 Small stocks lost to large stocks
• 1995 Small stocks lost to large stocks
• 1996 Small stocks lost to large stocks
• 1997 Small stocks lost to large stocks
• 1998 Small stocks lost to large stocks
• 1999 Small stocks lost to large stocks
• 2000 Small stocks lost money
• 2001 Small stocks BEAT large stocks AND made money!
• 2002 Small stocks lost money
• 2003 Small stocks lost money
• 2004 Small stocks BEAT large stocks AND made money!
  (*I used the Russell 2000 Index for small stocks, and the Dow for large stocks.)

Since 1994 the median return on small stocks in January has been -0.2%. Said another way, since 1994, the January Effect has been a money-losing strategy.

The returns on small stocks in January have been so bad since 1994 that I would suggest getting rid of any broker or publication that is pitching you on buying stocks right now to take advantage of this supposed January effect that doesn’t exist anymore

In short, the January Effect is an interesting historical anomaly-one that hasn’t been profitable for many years, and in my opinion will never be profitable again.

Today’s IU Cribsheet

• In today’s letter I talk about how trading phenomena like the January Effect stop working when everyone catches onto them. Another way of putting this comes from legendary trader Daniel Drew: “The way to make money in Wall Street is to calculate on what the common people are going to do, and then go and do just the opposite.” To read more about Drew and how he made a fortune in the markets, check out IU E-Letter #319: “What Always Works.”
  

Good investing,

Steve

P.S., Interested in learning more about the January Effect and timing your investment strategy? Take a look at these related IU issues from our Archive:

How Zweig’s ‘Bright Idea’ Could Ruin Your New Year: Issue # 300
Wall Street’s Deadest Month: Issue # 260