“The January effect is a real and continuing anomaly in stock-market returns,
and one that defies easy explanation.”

— Financial Analysts Journal (2006)

With December half over, it’s time to start thinking about the “January Effect.” Just to be clear, I’m not talking about the deeply-flawed “First Five Days of January Indicator” which says that how a stock market performs during the first trading week of January determines how it will perform for the entire calendar year. I briefly mentioned the 5-day January Indicator in a 2011 article entitled What’s Wrong with India’s Stock Market?” As it turned out, the 5-day January Indicator accurately predicted that India’s stock market would continue underperforming for the rest of 2011, but I digress.

Unlike the dubious 5-day January Indicator, the January Effect is an academically-proven stock-market phenomenon where small-cap and underperforming stocks near the end of one calendar year suddenly reverse course and outperform the general stock market in the January of the following calendar year. That this well-publicized phenomenon continues to occur despite being well known is interesting – the efficient market hypothesis argues that such abnormal outperformance should quickly dissipate at the hands of arbitrageurs.

Jeffrey Hirsch of The Stock Trader’s Almanac calls the January Effect “Wall Street’s only free lunch.” I would argue that diversification also qualifies as a free lunch, but Hirsch’s point is well taken. Based on 38 years of data between 1974 and 2012, Hirsch has found that a portfolio of small-cap stocks hitting 52-week lows in mid-December outperform the NYSE Composite Index (^NYA) by an average 9.5 percentage points (not annualized!) per year between late December and the January/February period. Just as impressive as the magnitude of outperformance is the frequency of outperformance — these beaten-down stocks have outperformed the NYSE Composite in 33 of the 38 years (87% of the time).

Hirsch is not the only one to find this outperformance. Studies galore have reached the same conclusion, including:

• Ned Davis Research: Between 1996 and 2009, a portfolio of stocks in the lowest market-cap decile of the S&P 1500 composite index that are also close to a 52-week low  outperforms the S&P 500 by an average of 7.4 percentage points between mid-December and the end of January. The outperformance is much less if you exclude December and look just at January, so investing in the strategy should not wait until January.

• Professors Eugene Fama and Kenneth French: Between 1927 and 2009, the lowest market-cap decile of stocks (average market cap of $100 million) performed more than eight times better in January than in the average of the 11 other months, whereas large-cap stocks actually underperformed in January compared to the average of the 11 other months.

Why do these December small-cap stock laggards persistently outperform in January? Hirsch attributes it to tax-loss selling by individual investors who want to dump losers before year-end in order to neutralize realized capital gains from their winning trades. But that is only one possibility, which is partially negated by the fact that since the passage of the Tax Reform Act of 1986, the tax year for institutional investors – which account for more than 70% of all stock trading — ends on October 31^st, not December 31^st.  What tax-loss selling does take place in December is limited to individual investors. Since the average individual investor often focuses his trading on low-priced and higher-volatility small-cap stocks, it makes sense that any tax-loss selling effect in December focuses on small-cap names. According to Columbine Capital, other causes of the January Effect may include:

• End of the year “window dressing” by institutional investors (e.g., mutual funds) who want to eliminate embarrassing losers from their portfolio prior to their end- of-year annual reports.

• January investment of end-of-year employment bonuses.

• The postponing of the sale of winning stocks that experienced capital gains until January in order to defer taxes to the following year. 

Taking advantage of the small-cap January effect can be problematic if the only bargain stocks ready to pop in January are microcaps worth $100 million or less, as the Fama-French data suggests may be the case. Microcaps are often illiquid with wide bid/ask spreads that make trading in-and-out of them exorbitantly expensive. Gains from such microcap stocks can be statistical mirages based on nothing more than one trade being executed at the bid and the next trade being executed at the much-higher ask. Furthermore, as James O’Shaughnessy writes on page 53 of his investment classic — What Works on Wall Street (4th ed.):

Microcap stocks possess virtually no trading liquidity, and a large order would send their prices skyrocketing. Thus, while it is easy to assume that you could purchase and sell these securities at their listed price in the historical dataset, I believe that this is an illusion and unnecessarily gives an upward bias to the results of studies that allow their inclusion.

Simply buying a small-cap ETF like the iShares Russell 2000 (NYSE: IWM) of the iShares Russell Microcap (NYSE: IWC) doesn’t work. Over the past 11 years, the Russell 2000 index (median market  cap of $460 million) has declined in January seven times (64% of the time) and has actually performed worse than the S&P 500 a majority of the time (6 out of 11). The Russell Microcap index (median market cap of $152 million) has only been around for seven Januarys (since 2006) and it has underperformed the S&P 500 in four of those years (a majority of the time). December relative performance has been no better for IWM, which underperformed the S&P 500 a majority of the time over the past 11 years, but IWC has done much better in December, outperforming the S&P 500 in each of its first seven years of existence. Like I said earlier, however, microcap “gains” are suspect.

Fortunately, a 2010 academic paper has demonstrated that the January Effect is not limited to stocks that are microcaps or have plummeted in price! Based on the authors’ statistical analysis using regression equations, they were able to screen out un-investable microcaps under $250 million, as well as mortally-wounded penny stocks under $5.00 per share, and still be left with a stock universe that generates a substantial January Effect.

According to their regression analysis, the real determinant of the January Effect is a stock’s current relationship to its 52-week high as of the market close on the last trading day of November (i.e., less than two weeks ago!). The nearer to its 52-week high, the worse the stock performs in January and the closer to its 52-week low, the better it performs. Using this metric, small-cap stocks do not perform better than large-cap stocks, nor do the worst-performing stocks at 52-week lows perform better than stagnant stocks near 52-week lows.

This is GREAT news because it means that average investors can benefit from the January Effect with liquid, large-cap stocks! According to the authors of the paper, this blockbuster conclusion means that tax-loss selling by individual investors is not the primary cause of the January Effect. Rather, window-dressing by institutional investors is the primary cause:

When good news has pushed a stock’s price to, or near, a new 52-week high, then fund holders may perceive it to be a good investment.  On the other hand, when bad news pushes a stock’s price far from its 52-week high, fund holders view it as a poor investment. Using the 52-week high as an “anchor” when assessing the stock’s performance is a bias because fund holders do not rely on the stock’s entire cumulative return history, but rather they base their judgments entirely on the highly visible 52-week high reference price.

Fund managers are aware of this cognitive bias and have incentives to window-dress by selling stocks whose December prices are far from the 52-week high, and buying, or continuing to hold, those with December prices near the 52-week high. In January, after the reporting period has ended, prices reverse.

In fact, the study’s authors found that 52-week stocks with extremely poor price performance actually rebound less in January than 52-week low stocks with stagnant price performance. This makes sense to me since stocks that plunge in price usually have downward momentum that continues. Severe price plunges also suggest serious fundamental problems, whereas stocks that simply stagnant could just be undergoing a pause that refreshes. Interestingly, the authors also found that stocks near their 52-week high underperform in January, especially those that don’t have strong year-to-date price appreciation (i.e., momentum), so one can enhance the January Effect by not only buying stagnant 52-week low stocks but also shorting stagnant 52-week high stocks.

Using my trusty Bloomberg terminal, I screened for stocks that are in the bottom two deciles of their 52-week price range and which also have not declined by more than 20% year-to-date. As of December 23rd, ten promising candidates for January outperformance are listed below:

January Effect Stocks Near 52-Week Lows

Source: Bloomberg

My top-ten list from last year outperformed the S&P 500 by 13.3 percentage points (19.8% vs. 6.5%) between December 21st and February 15th. Furthermore, the outperformance was not caused by only one or two big winners — eight out of the ten screened stocks outperformed the S&P 500. No guarantees, but I’m hopeful the current list will also outperform the S&P 500 this year.

Around the Roadrunner Portfolios

Buckle (NYSE: BKE) announced a special dividend of $1.20, which is the lowest special dividend since the company started announcing them late in each calendar year since 2006, but it is better than the “zero” some analysts were predicting given the weak U.S. retail environment. Furthermore, the company increased its regular dividend for the first time in five years ($0.02 per share, a 10% increase). The stock will go ex-dividend for both the regular and special dividend on Monday, January 13^th.

GrafTech International (NYSE: GTI) reported third-quarter sales and earnings that were down from last year, yet the stock soared 37.5 percent over the next three trading sessions on news that the company was initiated a corporate restructuring that would cut costs (including a 20% workforce reduction). Moody’s was less jubilant than stock investors, calling the restructuring announcement a “positive first step” but insufficient to justify a credit upgrade.

Arcelor Mittal recently stated that the global steel industry has “turned the corner” and the bottom of the industry cycle is now firmly in the past. Good news for all steel-focused stocks! Based on GrafTech’s restructuring news and the positive signs of a general steel industry recovery, I am raising the “buy below” price on GrafTech International to $10.

United Therapeutics (Nasdaq: UTHR) skyrocketed more than 30% on December 23^rd on news that the FDA had approved its first-ever version oral form of trepostinil (Orenitram). As opposed to trepostinil dosed through injection (Remodulin) or inhalation (Tyvaso), an oral pill has always been the holy grail for PAH therapy. Orenitram – and the many other forms of oral trepostinil that are likely to follow — promises much wider patient use of UTHR’s trepostinil drug franchise. Great news, as chief operating officer Roger Jeffs stated in the press release:

This approval marks the first time that the FDA has approved an orally administered prostacyclin analogue for any disease — and our fifth approval from the FDA for treatment of PAH — supporting our mission of providing a wider choice of PAH therapies for physicians and patients. We are grateful for the FDA’s thorough review and will continue to build clinical support for the use of Orenitram.

The stock shot up so high because FDA approval was a complete surprise – virtually no Wall Street analyst had included oral trepostinil revenues in financial estimates.

With the stock up so much, some insiders are selling (including $1.5 million worth by CEO Martine Rothblatt), so more near-term upside may be limited. In addition, a government inquiry into the company’s marketing practices may inject some unwelcome uncertainty into the stock. The good news outweighs the bad, however, and Ladenburg Thalmann upgraded the stock to buy with a $138 price target. Based on the FDA approval of oral trepostinil, I am raising the “buy below” price on United Therapeutics to $87.50.

US Ecology (Nasdaq: ECOL) suffered a hiccup on December 2^nd when the company issued revised earnings guidance for 2013 that was better than expected. As much as $0.12 per share of earnings will shift into 2013 from 2014, which will make 2013 financial results even more outstanding. Yet, the stock sold off on the news because the company also revised downward 2014 earnings guidance by $0.12 per share, which will make it very difficult for the company’s 2014 results to show any year-over-year earnings growth.

From a stock-valuation standpoint, this earnings acceleration is actually a positive since the company is getting the income sooner (time value of money). But psychologically, some investors don’t want to own stocks that are expected to exhibit stagnant or declining year-over-year earnings growth. This investor aversion caused a temporary period of price weakness, but the stock has since recovered back up above $37.

In addition, the company announced a secondary offering of 2.6 million shares at a price of $34 per share. Since there are currently only 18.51 million shares outstanding, this secondary offering dilutes shareholders by more than 12%, but the company said it needs the money for “general corporate purposes” including debt repayment and potential acquisitions.

Companies typically only sell new shares when management believes the stock is close to fully valued, so the stock offering may indicate that the company needs time to grow into its current valuation. US Ecology’s business is performing great, but its stock price has risen in tandem with its improved prospects. I remain committed to the current “buy below” price of $32.