Playing the "January effect"

Tue Jan 10, 2012 2:12pm EST
 
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By John F. Wasik

(Reuters) - For years, one of the more bankable phenomena in finance has been the January effect.

The premise is simple: Institutions and traders sell off stocks the end of the year for tax reasons and portfolio dressing. Then they start buying again in January, often favoring small companies, also known as "small caps."

With myriad signs that the U.S. economy is in recovery, this may be another good year for the January effect. Even if it isn't - and I refuse to make predictions for short-term traders - it would be a good idea to add bargain-priced small caps to your core portfolio through index mutual funds or exchange-traded funds (ETFs).

While there's certainly some controversy about whether the January effect is legitimate since its "discovery" in 1942, there are behavioral reasons why it may exist. Many investors like to clear out their deadwood by the end of the year and start afresh in January.

Instead of adopting new resolutions, they buy stocks. That's one theory, anyway. Since 1991, the average January return on the S&P 500 Index has been 6.7 percent.

Another view is that after a holiday respite, investors are looking for new, profitable ideas. Since last year's stock market, as measured by the S&P 500, was virtually flat, it's understandable that investors are hoping for a change of pace and a robust January may set the tone for the rest of the year.

JANUARY EFFECT HARBINGER

Since institutions, which dominate the market, migrate from category to category like sheep in a field, they may shift from once-favored stocks - such as large companies - and move into small caps. Is this happening now?   Continued...