Heading into December, most peoples’ thoughts are probably turning toward the celebration of Christmas and other seasonal holidays.  The end of the calendar year also reminds us naturally of the New Year, which then leads to the realities of tax planning and other associated fiscal matters. 

Also during this time of year, institutions have to reposition their money.  They take tax losses when necessary and trim other poor performers from portfolios so those don’t have to show up in reports to investors.  All this activity leads to several seasonal tendencies that have proven quite robust over many years. Let’s look at a few of these trends that may prove helpful in guiding your trading and investing in the coming weeks. 

We’ll look at typical returns for the month of December, throw in some 3rd year presidential cycle data, and end with a fairly broad look at a concept receiving a lot attention lately—the January Effect. 

December: A Historically Good Month to Be Invested

Historically, December is one of the strongest performing months of the calendar year.  Depending on the study length and market index one uses, December almost always shows up as the first or second best performing month.  The driving force could be the hope and good feelings that come with the Christmas season and associated holidays or some other psychological underpinning, researchers don’t seem to know exactly.  Regardless of the reasons behind it, consider these numbers:

• December has provided positive returns in 75% of the years since 1950 (46 out of 61) and has averaged a 1.5% return for the month using the S&P 500 Index.
• The last 31 years have provided almost identical performance.
• Of the last 15 pre-election-year Decembers (dating back to 1950), 11 have been positive (still around 75%) with returns almost 80% higher than the average year.

And speaking of the presidential election cycle, much has been made lately over the fact that the 3rd year or the pre-election year of the cycle has seen positive returns ever since the Great Depression. That’s 19 in a row.  With one day left in November, the Dow Jones Industrial Average is less than 20 points from its 2010 close. If we have even a slightly positive December, chances look good that the streak will continue.

The January Effect: It Still Works, Just Sooner Rather than Later

Traditionally, the January Effect describes the persistent phenomenon of small cap stocks outperforming their larger cap counterparts in the month of January.  This has actually been one of the best documented and researched seasonal tendencies around.  Here’s a summary of some of the research that’s out there pulled from articles in the Wall Street Journal, Forbes and Agora’s Money Morning:

• The CBOE found that from 1980 to 2006, small caps in the Russell 2000 outperformed the S&P 500 and the Dow by posting average returns of 2.5% versus 1.7% and 1.6% for the large cap indexes, respectively.
• From 1927 through 2004, small stocks beat large stocks by an average of 2.5 percentage points during January, according to research by University of Kansas professors Mark Haug and Mark Hirschey.  Cheap stocks beat more expensive ones by 2.4 points according the Wall Street Journal.
• Each December, Ned Davis Research sends out a list of its January Effect Stocks, which is generated by screening for the smallest 150 stocks in the Standard & Poor's 1500-stock index that are also among the 10% of stocks furthest from their calendar-year closing high. From 1996 through 2009, the portfolio returned an average of 8.6% from mid-December through the end of January, well above the 1.2% gain in the S&P 500. From January 1 to the end of the month, however, it returned just 3.5%.
• Hirsch and Hirsch report in the Stock Trader’s Almanac that small caps far outperformed big caps 40 out of 43 years between 1953 and 1995.

The January Effect had become quite well-known by the early 1990s, and as more players jumped on the bandwagon, the effect has weakened.  The Wall Street Journal reports that in the 1970s, a portfolio of small caps outperformed one comprised of large caps by 5.1% during the month of January. That edge or outperformance dropped by more than 80% to only 1% during the 1990s.

Hirsch and Hirsch report similar findings.  And further refining the change in performance, the Hirsch duo found that significant small cap outperformance still exists; however, now it has moved to the last two weeks of December!

Comparing the Russell 2000 small cap index with the Russell 1000 large cap index, the Hirschs found that the small cap index’s average return was 2.37 times more than the big caps for the last two weeks of December (annualized rate of 119.9% versus 50.5%).

The Hirschs are in good company noticing that small cap out performance is front-running January and moving into December.  Ned Davis was already cited above.  And Nigam Arora, a hedge Fund manager and researcher reports in Forbes that he also jumps in ahead of January and starts his small cap/depressed stock investment strategy in December.

Possible Trades

Fortunately, Exchange Traded Funds (ETFs) make it easy to play these late December tendencies that used to be the January Effect.  For example, it’s very reasonable to expect the iShares Russell 2000 Index Trust (Symbol: IWM) to outperform its larger cap brethren in the second half of the month.

As we enter December, the market has shown positive results for the month in the past.  And while a 75% winning percentage provides a good edge, it is not infallible.  As always, apply sound risk management strategies to every trade! 

Whatever your faith practice, my prayer is that this season of hope, joy, and love is a blessing for you and your family.

I’d love to hear your thoughts and feedback. Just send an email to drbarton “at” vantharp.com.  Until next week…

Great Trading,
D. R.

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