Thankfully, a new year is upon us. We can relegate 2009 to the dustbin of history. Hopefully, greater things are in store for investors in 2010. But with all this economic uncertainty floating around, who knows exactly where the market will end up a year from now? Interestingly enough, there is one well-known investing phenomenon that many folks think may give us a clue as to where stocks are headed in the next 12 months.
As goes January, so goes the year
The January effect refers to the little blip the market frequently gets in the opening days of the New Year. As the story goes, investors sell losing positions right at year-end to take a tax loss. Then, they reinvest that money in the first week of January, causing a bump in stock prices and trading volume. The January effect doesn't always work, but history has shown that it can frequently serve as a reliable indicator of how the rest of the year will play out for stocks. When the first five trading days of January are up, then most of the time, stocks also end the year in positive territory.
According to the Stock Trader's Almanac, a publication that tracks market trends, there have only been five years since 1950 when the January effect failed to predict the general direction of the stock market by year-end. That's a pretty impressive track record. After all, if a professional money manager managed to correctly predict the path the stock market would take 92% of the time, wouldn't you sit up and take notice?
So how can investors take advantage of the seemingly awesome predictive powers of the January effect? Well, because this effect seems to be more pronounced for small-cap stocks, theoretically, you could snap up a few smaller companies and ride the early-year rebound. It's theorized that many fund managers sell their shares of riskier small companies to make their year-end balance sheets look more solid, and then buy those shares back early in the New Year.
If you wanted to play this game, you could look for relatively cheap small- and mid-sized names like consumer products manufacturer Lancaster Colony (Nasdaq: LANC ) , specialty retailer Gymboree (Nasdaq: GYMB ) , or automotive parts supplier Dorman Products (Nasdaq: DORM ) , all of which sport P/E ratios between 12 and 14. No doubt that's what some day-trading folks do at year-end in hopes of making a quick buck.
However, it's not a given that the January effect will materialize in 2010, or more importantly, that it will be a reliable market indicator for the whole year. We're in the initial stages of a very fragile recovery, and it won't take much more than a downbeat jobs report or news of a developing financial crisis in another nation to pull the market back down. And while it may appear that the January effect is a reliable market indicator, we've just come through an unprecedented crisis, which means that things may not play out the way they have in the past.
Theory vs. practice
Also, after being discovered, the January effect is now typically priced into the stock market at the end of December. That means it's becoming more difficult for day traders and the like to capitalize on any potential gains. And that's probably a good thing. Short-term thinking and a focus on near-term profits is part of what led us to the crummy economy we have right now.
So what should you do if stocks end up in the black after the first week or two of January? Well, the same thing you should do if they end up down -- absolutely nothing. While it makes a good story, long-term investors shouldn't use the January effect as a trading signal. Continue to invest for the long run, regardless of what the market does in the next few weeks.
And while small-cap stocks may benefit in the early part of the year, over the next year or so, I think there's actually more potential in larger names. Higher-quality blue-chip names have stayed out of the spotlight so long, they're probably overdue for a comeback. As the economy struggles to get back on its feet and citizens struggle to get back to work, consumer stocks like Kellogg (NYSE: K ) and General Mills (NYSE: GIS ) are likely to do fairly well, as investors stick to buying basic staples and essentials. Likewise, you might want to make space in your portfolio for big-name tech stocks like Microsoft (Nasdaq: MSFT ) and Cisco Systems (Nasdaq: CSCO ) , which should benefit from a rebound in technology spending this year.
So keep an eye out for this year's January effect -- but for entertainment purposes only! It might make for interesting watching, but short-term trading trends shouldn't be part of any long-term investing program. Here's to hoping 2010 is a good year for stocks, regardless of what the month of January has to say about it.