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Re: frenchee post# 56

Friday, 01/09/2009 9:23:03 AM

Friday, January 09, 2009 9:23:03 AM

Post# of 83
He wrote about "The January Effect" -- Santa didn't make his hit parade.

Year-end bounce for small caps?
Commentary: January Effect particularly risky bet this year

By Mark Hulbert, MarketWatch
Last update: 12:24 a.m. EST Dec. 22, 2008

ANNANDALE, Va. (MarketWatch) -- Ordinarily, I would feel comfortable urging you to consider a strategy over the next couple of weeks that attempts to exploit the so-called January Effect.

But, as is abundantly clear, we are not in ordinary times.
So let me review the historical evidence, and you be the judge.

The January Effect, of course, is the seasonal tendency for stocks of small companies to outperform the large-caps around the turn of the year. Its existence has been widely known for over two decades. And in back testing, researchers have found that it existed in many prior decades too.

In fact, it is one of the strongest historical patterns that researchers have ever documented in the stock market.
Furthermore, despite predictions that widespread awareness of its existence would cause it to disappear, the January Effect -- with some notable exceptions -- has remained remarkably robust. In fact, some of its most profitable years have come this decade.

Why, then, am I so cautious?

Because the January Effect appears to owe its existence in large part to investment managers' increased appetite to invest in riskier stocks once the New Year begins. That appetite will be dampened if the bear market takes another leg down over the next couple of weeks, causing those managers to avoid the riskier small-caps.

There's a fascinating story in why managers should be more willing to incur risk in January than in December. According to researchers, it has to do with the benchmark that managers must outperform in order to earn their year-end bonuses. By far the most commonly used one is the S&P 500 index (SPX), and though the choice of that benchmark would appear to be completely innocuous, it actually has profound consequences for how managers behave.

Consider first a manager who is ahead of the S&P 500 for year-to-date performance as the end of the year approaches. This manager knows that if he can hold on to his lead above the S&P 500 until Dec. 31, he probably will earn a decent bonus. He thus will have an incentive to make his portfolio look more and more like the S&P 500, since that locks in his lead. That means he will tend to shift money out of secondary stocks that are not part of the S&P 500 and into the large caps that dominate that index.

Money managers who are only moderately behind the S&P 500 as the end of year approaches also will have an incentive to reorient their portfolios to be more like the S&P 500. That is because their desire to take on more risks in order to possibly rise above the S&P 500 by year's end will be outweighed by the fear of losing their bets and lagging the S&P 500 by an even large margin -- in which case even their jobs might be in danger.

One implication of this reduced appetite for risk as the year progresses is that the beginning of the year will be a lot different than the end of the year. That's because, once Jan. 1 rolls around, managers' compensation slates will be wiped clean. Their willingness to take risk, which often manifests as an eagerness to bet on secondary stocks, will be at the highest point it will be all year. That in turn means that managers in January will likely be net sellers of the large caps they increasingly purchase in November and December.

I admit that this may sound like an awfully fanciful theory. But researchers have found extensive evidence that the theory is a good description of how managers behave. ( Read academic study on the subject.)

But what happens if investors panic around the turn of the year and there is a market-wide flight to quality?

It turns out that we got a textbook illustration of this one year ago, and its influence on January Effect strategies was not pretty. While both large caps and small caps declined, small caps suffered the most. As a result, January Effect strategies turned a sizeable loss last year.

And it's a good bet that the same thing would happen again this year if panic conditions exist over the next several weeks.

So there you have it: Betting on the January Effect this year requires a belief that there will be at least somewhat of a return to normalcy in managers' willingness to take on risk.

If you are willing to make that bet, exchange traded funds probably provide the easiest investment vehicles with which to do so. You would purchase an ETF that invests in small-cap indexes, such as the iShares Russell 2000 fund (IWM), while simultaneously shorting an equal dollar amount in an ETF that invests in the S&P 500, such as the iShares S&P 500 fund (IVV).

Not all January Effect strategies use the same entry and exit dates. But one early study used Dec. 20 as the entry (or the close of the first trading session after Dec. 20 if the market was closed on that day), and Jan. 9 as the exit. For tracking purposes, therefore, I'll assume that this hedge is entered into at the close of Monday, Dec. 22, and exited at the close of Jan. 9.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

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