The January Effect

Will markets warm, or be just as cold as December?

January is supposed to be the month in which investors get their Christmas gifts, especially investors who like small cap stocks.

Academic studies have confirmed Wall Street lore that in the first month of the year small cap stocks achieve 50 percent of their gains for the entire year. And on top of that, smaller companies traditionally outperform corporations with bigger market values more than 80 percent of the time.

No one is exactly sure why this happens, and after months of being battered by earnings disappointments, the dot-com meltdown, the shutdown of initial public offerings and a shriveling debt market, analysts were not certain what to expect come Jan. 1, 2001.

"Lately we have been praying for that [January effect] a lot," says Steve Levy, managing director of telecommunications research at Lehman Brothers Holdings. "I dont know at all what is going to happen."

If history is any precursor, the stock indices should bounce up. Research firm Ibbotson Associates found that small cap stocks did better in January in 56 of the 69 years between 1926 and 1995. Mitch Carpen and Russ Koesterich, analysts at Instinet, cite studies by academicians that show smaller stocks on the New York Stock Exchange outperformed larger ones in January by almost 11 percent from 1926 to 1981. From 1982 to 1995, the gap narrowed to 4.48 percent, but was still there.

The Instinet researchers crunched their own numbers and found that between 1996 and 1999, the performance difference was only 1.98 percent. Koesterich says small cap stocks were depressed in general for most of 1996 through 1999, but did better in January 2000.

The January effect has helped stocks with low price-to-earnings (P/E) multiples, as well as value stocks — that is, those with shares that are low relative to book value. Book value is the value of a companys assets as stated on its balance sheet.

Highs and Lows

Between 1991 and 1999, stocks with low P/Es had a 3.5 percent return in January, compared with 2.75 percent for the overall S&P 500, the analysts say. Value stocks registered a 2.98 percent gain vs. 2.28 percent for growth stocks. They compared the Russell 1000 Value index with the Russell 1000 Growth Index. A growth stock has a high price-to-book ratio.

The most widely accepted explanation for the January effect, Noone says, is the reinvestment of proceeds from "tax-loss selling" in December. Tax-loss selling is when investors sell shares on which they can record losses to offset gains on other investments.

Small stocks supposedly are neglected during the year and noticed when investors change their portfolios at the start of a new year. Portfolio managers are thought to sell lesser-known stocks before a funds reporting period ends to make the fund look better — a practice called "window dressing." Then the managers buy the stocks back in January, giving the market a bounce.

Carpen and Koesterich say there is some evidence that the January effect has moved up and is now happening in December. In addition, because small cap stocks had significant gains in 2000, they may not have any uptick this January, the researchers say.

In a twist, large cap stocks have been beaten down so much this year that there may be good opportunities for investors in that group, according to Carpen and Koesterich. They looked at 1,000 large companies with relatively low P/E multiples that might be good candidates for the January hop, and found 86 possibilities. Among them were several semiconductor manufacturers, but, needless to say, no Internet or networking vendors.

Internet stocks are not good candidates because "most of them have no E to go with the P," Koesterich says. However, it is possible that networking stocks, the valuations of which have been cut drastically in recent months, might move into this universe.

Uncertainty about the economy and where the stock market is headed in 2001 may deflate any bounce in January, warns Andy Schopick, a securities analyst at Nutmeg Securities of Westport, Conn. Companies that have positive cash flow, earnings and cash in the bank, yet their stocks have been beaten down, will revive later in the year, Schopick says.

One such company is Turnstone Systems, a supplier of management software for Digital Subscriber Line carriers, he says. Its shares fell below $8 from a high of $107 after announcing a sales slowdown.

David Tilkin, president of Navigator Consulting Group, a Norwell, Mass., supplier of investment software tools, takes note of the history of the January phenomenon effect and its benefits for small corporations, but says, "Investors should look to companies where there are earnings and meat on the bone."