With the New Year looming many investors are reviewing their stock portfolios. This is because of the so-called “January Effect”, the idea that January, on average, sees a general increase in stock prices. This is supposed to follow the “December Selloff” where there is a general decrease in stock prices.

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The explanation is rooted in the idea that investors sell their losing positions in December before buying them back in January.

However, according to Moneychimp, that is a bit of an urban legend. From 1950 to present, data from the S&P 500 shows that December has seen a better overall return than January, 1.6% vs. 1.0%.

The market tends to have strong returns in December and January as well as during the summer months but as you can see in the figure below, December actually slightly outperforms January. The reasons for this are unclear. It may be due to the holiday effect, the notion that investors are generally positive – which drives up stock prices.

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What is the Real January Effect?

So if the data does not match the standard story then what can investors expect as we move through December and into January?

Since 1925, data suggests that small-cap stocks outperform the broader stock market from mid-December through January. This is the actual “January Effect”.

Small-cap and large-cap are terms used to describe the size of companies. Small-cap stocks are shares of smaller companies while large-cap stocks are shares of larger firms. The size of the company is measured via its market capitalization, which is the dollar value of all of a company’s outstanding shares. The market capitalization, or market cap, of a firm can be seen as the market’s estimate of the value of that firm.

The exact size can vary but in the category of small-cap stocks, companies are generally worth less than $2 billion.

For example:

(OVTI, $1.6 billion market cap):  Designer of high-performance semiconductor image sensors.

(ACOM, $1.4 billion market cap): Look up your family tree on this subscription based genealogy research website. They have a huge collection of digitized historical records that make it easy to discover more about your family history.

On the other hand, large-cap stocks refer to companies with a market cap of over $10 billion. These are the big players and include recognizable names such as Wal-Mart, Google and Apple.

Bargain Sale

Investors tend to dump their small-cap losers before the year-end in order to record their losses. These small cap stocks are then relative bargains – setting the stage for a recovery into January.

“According to the Stock Trader’ Almanac, between 1953 and 1995 small-caps outperformed large-caps in January 40 out of 43 years”. Then the out-performance start to extend out into December as investors got wise. In 2012, the small-cap out-performance started in November!

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The Russell 2000 is a small-cap stock market index of the bottom 2000 stocks in the Russell 3000. The Russell 2000 represents 8% of the total market capitalization of the Russell 3000 and is the most common benchmark used by mutual funds that identify as “small-cap”.

The Russell 1000 represents the top 1000 stocks of the Russell 3000 and measures the performance of the large-cap part of the U.S. stock market.

So we can see how the ratio of the Russell 2000 to the Russell 1000 would approximate the performance of small-cap to large-cap stocks and that is precisely what we see in the chart above – which shows small-cap stocks start to outperform their large-cap counterparts beginning in mid-December, continuing all the way into June.

Not Just Performance

In order to claim capital losses for tax purposes, many investors will sell off their losers during the last few trading days of the year. Big mutual funds will dump their worst performing stocks and move into ones with a history of outperformance.

A lot of investors are also looking to get rid of their small-cap stocks as the New Year approaches, as these stocks are typically riskier, and move into more stable large-cap stocks. Large-cap stocks have huge trading volumes compared to small-cap stocks and are less likely to be affected by tax-loss selling.

We already explored how small stocks outperform their larger counterparts starting from the second half of December.  Ordinarily when a market trend is discovered its usefulness tends to dissipate but the “January effect” is still going strong.

That doesn’t necessarily mean you should throw all your dollars at small-cap stocks starting on the 15th of December.  Your buy list should contain small-caps that have sustained big year-to-date losses – the ones most likely to stage a strong comeback as January approaches. You should still only aim to buy stocks with sound fundamentals, even at this stage, as you don’t want to be saddled with a financial write-off.

Finally, as we approach the holiday season there are certain stocks that perform better than others. Your head may be consumed with thoughts of wrapping presents and putting up lights rather than investment strategies but for certain categories of stocks, there is a definite “holiday bump”.

Not surprisingly, companies that specialize in consumer products do very well during the end-of-year rush. Retailing stocks, including online retailers, credit card services and shipping and transportation stocks all tend to do well during this period.

For example:

(MAT): A toy and game manufacturer which carries some of the world’s most popular toy brands (Barbie, Fisher-Price, Hot Wheels).

(PHG): It should not come as a surprise to hear that consumer electronics do well during the holiday season, and Philips is a big player in that market.  With a market cap of nearly $29 billion this electronics giant is a good bet for the holidays.

(FDX):  With so many people doing their shopping online it makes sense that shipping companies stand to benefit. In 2012 FedEx’s share price rose from $83 to $93 between November 16 and December 19.

As always, there are exceptions to any pattern – especially when it comes to the stock market.

Invest wisely!

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