How to Monitor the January Effect in 2010

Jan 4, 2010: 11:03 PM CST

Many traders are throwing around the term “January Effect,” especially as we turn the corner into January 2010.  Some are trying to profit from the “January Effect,” but what is this ‘effect’ and how can we monitor it?  Let’s find out.

According to Wikipedia, the January Effect is defined as a “calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.

Therefore, the main characteristics of the January Effect are an increase in buying securities before the end of the year for a lower price, and selling them in January to generate profit from the price differences.”

The main idea is that investors ‘dump’ shares of small capitalization (cheaper) stocks – which are more volatile – and then when these investors reinvest, they may buy additional small cap stocks, which will be better bargains and also rise faster than less-volatile large cap stocks (Blue Chips).

Thus, small cap stocks tend to ‘outperform’ large cap stocks in January.

Wikipedia and many other sources highlight that this effect is not set in stone, with the statement, “the January effect does not always materialize; for example, small stocks underperformed large stocks in January 1982, 1987, 1989, 1990, and 2008.”

Without comparing individual stocks to each other, how else might we observe whether the “January Effect” is working or not?

Simply take a ‘relative strength’ comparison of the Russell 2000 Index to the Dow Jones or the S&P 500 Index, or for trading purposes, compare the IWM (Russell 2000 ETF) to the SPY or DIA.

Here is what the current chart looks like:

Using StockCharts, type in the following:  IWM:SPY (IWM colon SPY) to generate a relative strength chart.

Take off all indicators and set the chart to a “Line” chart.

You then have is a relative strength chart of the Russell 2000 (small cap index) to the S&P 500 ETF (large cap).

What you have is a fraction.  If the top number is larger, the fraction is larger.  If the bottom number is larger, the fraction is smaller and vice versa.

So, when the relative strength line is RISING, we can say that “The Russell 2000 ETF is outperforming the S&P 500 ETF on a relative basis” which is exactly what we are looking for when discussing the January Effect.

If the relative strength line is FALLING, then the Russell 2000 would be UNDERPERFORMING the SPY, which is not what traders expect when discussing the January Effect.

As of the start of January 2010, one can clearly see that the January Effect may have come early this year – a full month early.

The relative strength line bottomed in late November and rose for the entire month of December.  If this line continues to rise, then we would observe the January Effect in its textbook definition.

Because the expectation of the January Effect is so wide-spread, what we’re likely seeing now is investors buying small-cap stocks in advance – in December – to play AHEAD of the January Effect, so it’s possible to see a reverse January Effect… but let’s not get too far ahead of ourselves.

Use this chart to monitor whether or not the January Effect is taking place in 2010.

Corey Rosenbloom, CMT
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  1. Tuesday links: not-so distressed debt Abnormal Returns Says:

    […] The market is going to do what it does regardless of the calendar.   (Daily Options Report, Marketwatch, MarketSci Blog, Afraid to Trade) […]