Inside The 'December / January' Effect
Your two best trading strategies for the holidays -- Small-cap stocks and closed-end funds have proven to be winners this time of year
by Howard Gold
Americans on Thursday will sit down at their Thanksgiving dinner tables before rushing out to score Black Friday deals at the mall.
And so will begin a five-week-long orgy of shopping and eating that culminates in a hangover on New Year's Day.
The markets also typically imbibe the holiday spirit: December and January are two of the best months for stocks. I expect this year to be no different.
The holiday season is particularly good for small-cap stocks and closed-end funds. And although I rarely focus on short-term trading strategies, those two have such solid track records that they're worth exploring.
Their outperformance is connected with the so-called January effect, which was first identified in 1942 by Sidney Wachtel. He noted that U.S. small-caps (these days, stocks whose market value is less than $2 billion) outperform larger stocks in January.
Why? Investors sell losing stocks in December to rack up capital losses to offset capital gains from other investments, thus reducing their tax liability.
Trouble is, the January effect became so familiar that investors began buying small-caps in December in anticipation. So now, "it's not a January effect per se anymore," said Jeffrey Hirsch, editor of the Stock Trader's Almanac. "Most of the January effect happens in mid- to late December."
In fact, some years ago, the Chicago Board Options Exchange re-dubbed it the December/Januart effect.
Whatever you call it, the data behind it is pretty strong. According to Hirsch, between 1974 and 2012, a portfolio of small-cap stocks that hit their 52-week lows in mid-December outperformed the NYSE Composite Index "by an average 9.5 percentage points (not annualized!) per year between late December and the January/February period." And they did so in 33 out of the 38 years studied.
So, are small-cap value stocks the way to go? Well, for the long run, yes, but Hirsch said during the seasonal trade, leadership changes year by year. "If you're going to play the small-cap effect, you just buy small-caps," he told me. You can use the iShares Russell 2000 ETF (IWM).
This year, the Russell 2000 small-cap index peaked in early July and then had a nasty correction that ended in mid-October. It's rallied 13% since, but Hirsch calls it "a very typical end-of-October rally" and expects to see small-caps outperform again through mid-January, when he typically unwinds his positions.
Another time-tested seasonal trade involves closed-end funds, mutual funds that issue shares once at their public offering and then trade like stocks.
There are around 600 closed-end funds with a total market capitalization close to $300 billion, so their average market capitalization is roughly $500 million - solidly in small-cap territory.
But daily price fluctuations cause closed-end funds to trade at premiums or discounts to their net asset values (the value of their holdings), and that's where the trading opportunity comes in.
Year-end tax selling reduces demand for closed-end funds and "because closed-end funds' share prices depend on supply and demand, the discount widens," said Thomas Herzfeld, chairman and president of closed-end fund specialist Thomas J. Herzfeld Advisors in Miami Beach. He started following closed-end funds in 1968, the year Richard Nixon was elected president.
This year's September-October stock market correction hit closed-ends "very hard," Herzfeld told me. "We were fortunate to buy a lot of those."
But he added, "I don't think that was tax selling; that was panic."
By mid-January, said Herzfeld, discounts narrow again as investors take profits from this seasonal trade.
One area he's looking at now: new issues. "They are typically brought to market at a premium, [but] it's not unusual to see 15%-20% discounts in new issues." In particular, the battered Energy sector (XLE) is ripe for a rebound, he said.
Bond funds comprise more than half of all closed-end funds. Herzfeld doesn't consider them good long-term investments, but noted that the "discounts are widening" there now.
His firm has a mutual fund, Virtus Herzfeld (VHFAX), which invests in closed-end funds. It's small and only two years old, so do your research.
"If you buy in December and wait a month, you can make a really good short-term trade," said Herzfeld. "Eight or nine years out of 10, that's a pretty predictable trade."
He expects the normal seasonal pattern to unfold this year, too. "It's shaping up pretty well," he said.
Courtesy of MarketWatch.com