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Small-Cap Stocks’ January Effect Tends to Make Early Entrance

November 30, 2015
What’s new with the January effect - small-cap stocks outperforming large-cap stocks.

Sometimes you’re stuck with the name you’re born with, even when it no longer fits. The well-documented “January effect,” which refers to the historical tendency for small-cap stocks to outperform large-cap stocks to start the year, may need a new moniker. Increasingly, the phenomenon is now the December effect.

The January effect (we’ll still call it by its given name!) is not new. Stock market watchers credit economist and investment banker Sidney Wachtel for coining the term back in 1942. 

Tax Man’s Pull

What’s the cause? "The January effect phenomenon is likely caused by year-end, tax-loss selling of small-cap stocks [which tend to be more volatile]. Selling, of course, drives their share prices down. These ‘bargain’ stocks are often bought back in January with the help of year-end bonus payments in January," explains Jeffrey Hirsch, editor at Stock Trader's Almanac.

Data shows that during January, small-cap stocks outperformed large-cap stocks 40 out of 43 times between 1953 and 1995. Then things began to change. 

Hirsch crunched the numbers using the Russell 2000 Index of small-cap stocks versus the Russell 1000 Index of large caps. "We went back to the beginning of the Russell data in 1979 and noticed that small-cap strength in the last half of December became even more magnified after the 1987 market crash," he says. 

He found a dramatic shift in gains in the last half of December during the 28-year period starting in 1987, versus the 36 years from 1979 to 2015. Since 1987, the Russell 2000 gains 3.5% on average in the last half of December versus 1.9% in the Russell 1000. Gains for the month of January are 0.6% for the Russell 2000 and 0.5% for the Russell 1000, according to Hirsch's data.

Different Kind of Door-Buster?

"With all the beaten-down small stocks being dumped for tax-loss purposes, it historically has paid to get a head start on the January effect in mid-December," Hirsch says. 

After all, traders are a savvy crowd who are often ready to jump on a well-documented market trend, and the time shift has only become more apparent.

"This is likely due to the anticipators trying to take advantage of this trend and getting in earlier. The pros and sophisticated traders come in during the quiet time at the end of the year, scoop up these bargains, and then take their profits early in January," says Hirsch. 

But an official name change? That may take a while.

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