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New Arguments for the January Effect

Written By Brian Hicks

Posted December 21, 2007

The latest January Effect article argues that capitulation lows, short covering sprees, low valuations, high cash and low to no debt, negative analyst coverage, strengthening U.S. dollar, and future M&A activity are good enough reasons to sink money solely into the January effect. While I’d agree that a stronger dollar would bring more investment activity back to the U.S., relying on the antiquated, unreliable theory isn’t a great idea.

As we said on December 11 , the January effect is the “expected” time of year when tax conscious investors sell stocks to write off losses against capital gains. The “tax sell-off” would depress stock values lower until buyers came back in early January.

And, yes, for awhile it was a flourishing, profitable theory. Bullish January effect theorists will remind you that from 1925 to 1993, small cap stock outperformed large cap stocks in January in 69 of 81 years. All you had to do was buy small cap stocks in mid-December and hold until the last day of January. It was like having a license to print money, as small caps, on average, returned 7% every January as compared to 2% for large caps.

But since 1994, for example, it’s had off and on years. Comparing the Russell 2000 to the Dow, using the dates of December 1st to February 1st as my parameters, for example, I found that in:

  • 1994, the large caps stocks outperformed small caps
  • 1995, the large cap stocks outperformed small caps
  • 1996, the large cap stocks outperformed small caps
  • 1997, the large cap stocks outperformed small caps
  • 1998, the large cap stocks outperformed small caps
  • 1999, small cap stocks outperformed large caps
  • 2000, small cap stocks outperformed large caps
  • 2001, small cap stocks outperformed large caps
  • 2002, small cap stocks outperformed large caps
  • 2003, small cap stocks outperformed large caps
  • 2004, the large caps stocks outperformed small caps
  • 2005, the large caps stocks outperformed small caps
  • 2006, small cap stocks outperform large caps
  • 2007, the large caps stocks outperformed small caps

Truth is, while the theory is still used, it’s not as reliable as it was from 1925 to 1993.

So how do you profit in January 2008. First of all, ignore the theory. Second, take a look at small cap stocks like MIPS Technologies (MIPS:NASDAQ), and see how they’ve technically performed every January, even in an economic slowdown. These are the “historical” gems you want to own for quick run ups.

As you can see in this chart, MIPS is sitting at multi-year support levels, as MACD and DMI, our momentum indicators, trade at multi-year lows. Also notice that every January, over the last five years, MIPS had a brief rally, which we’re looking to profit from. It’s then sold off in historic fashion shortly thereafter. This gives us an opportunity to profit from the long and short sides of MIPS.


MIPS multi-year chart

But what I really like about MIPS is how it’s historically behaved between December and January, despite slow-downs. Take the dot com, 9/11, and accounting scandal-induced recession of 2001 to 2003, for example.

To identify trend here, we overlay DMI and MACD. Notice in the one-year MIPS chart below that the MACD blue line has crossed above the red line. We’re now waiting for confirmation with a DMI+ cross above DMI-. We should see the beginnings of a nice-sized rally for MIPS when that happens.


MIPS 2007 chart

From December 2000 to January 2001, for example, MIPS ran from $26 to $36. Notice the agreement between DMI and MACD crossovers. They signaled the reversal off bottoms.
Note: I’m showing you the candlestick version of this chart to also point out the doji crosses at the bottoms.These represent a battle between the bulls and bears and can often signal a reversal at top or bottom of trend.
MIPS chart from December 2000 to January 2001

From December 2001 to January 2002, for example, MIPS ran from about $9 to about $13. Here, too, as seen in the chart, we had agreement with MACD and DMI. It happened twice between December and January.
MIPS chart from December 2001 to January 2002

In 2003, MIPS began its run earlier. This time, from November 2002 to December 2002, it ran from $2 to $3.50. While it ran a bit earlier than expected, notice that the technical set-up remained intact.
MIPS chart from November 2002 to January 2003

Again, look for small-cap stocks that have historically weathered slowdowns, and have historically risen every January. Individual stock research such as this is stronger than buying baskets of small caps, hoping the volatile January effect theory pays off.

Take care,

Ian L. Cooper