The New Year has begun, and investors have reset their expectations and are focused on finding early signs of how 2015 is likely to go. One popular gauge that many investors look at is the so-called "January effect," which proponents argue makes the stock market in general and small-cap stocks in particular go up in the first month of the year. Moreover, those who believe in the January effect conclude that if January turns out to be a bad month for the market, it's likely to translate into poor performance for the entire year.
Here are three ways you can take advantage of this supposed stock-market indicator.
1. Look at the cream of the crop of last year's losers
One of the justifications for the January effect is that many investors take advantage of tax-loss selling techniques to cut their tax bills. That typically involves selling losing stocks late in the year, which often pushes prices further downward. According to the theory, once the New Year begins, that selling pressure often disappears, which helps push stocks back upward.
On that theory, hard-hit energy stocks that have suffered from the crash in oil prices could stand to benefit. Continental Resources (NYSE:CLR), for instance, lost more than half its value in the last four months of 2014 as the exploration and production company with a huge stake in the Bakken shale play in North Dakota suffered from worries about the sustainability of its long-term growth in light of falling oil. Similarly, many small-cap gold and silver miners struggled through a poor 2014, and so companies like First Majestic Silver (NYSE:AG) and IAMGOLD (NYSE:IAG) arguably have more to gain from a January bounce.
Yet to benefit the most, it's still important to look at the fundamentals of each company. For instance, the energy sector has punished stocks across the board, regardless of their actual exposure to oil prices. Some master limited partnerships that focus on transporting oil and natural gas might actually benefit from lower prices, yet in large part they have fallen along with drillers that clearly have direct exposure to the price of oil. Stocks that have been unfairly beaten down in 2014 are the best prospects to win from a January effect.
2. Go with a broader approach
Because the January Effect theory says that small-cap stocks tend to outperform large-cap stocks early in the year, ETFs like the iShares Russell 2000 ETF (NYSEMKT:IWM) are a natural choice for those who don't feel comfortable picking individual stocks in the small-cap space. The iShares ETF tracks the popular Russell 2000 index of small-cap stocks, owning more than 2,000 small-cap names and managing more than $30 billion in assets. It's among the most liquid small-cap-oriented ETFs available, and it comes with a modest expense ratio of just 0.2% annually. With names like ISIS Pharmaceuticals (NASDAQ:IONS) and Triquint Semiconductor (UNKNOWN:TQNT.DL) among its top holdings, the ETF has broad-based exposure to some of the top performers in the small-cap space.
Especially this year, the January effect looks like a relatively compelling proposition from a valuation perspective. In 2014, the iShares small-cap ETF lagged the large-cap S&P 500 by around 10 percentage points. That's no guarantee that small caps will return to their winning ways in January 2015, but it does show the lack of attention that small caps have gotten lately. If the January effect refocuses investor attention on small caps, then the iShares Russell 2000 ETF should reflect their heightened enthusiasm with gains.
3. Take advantage of the stocks January-effect believers won't like
Perhaps the best way to take advantage of the January effect is to stay contrarian and look for stocks that traders won't see as good prospects. For instance, large-cap stocks in the consumer area like home-improvement giant Home Depot (NYSE:HD) and athletic-apparel pioneer Nike (NYSE:NKE) rocketed forward to gains of 20%-30% in 2014, making them unlikely candidates for a January effect bounce.
Indeed, proponents of the strategy might well sell off their large-cap winners to finance small-cap purchases. That could leave some of these stocks and similar high-quality companies trading at a relative bargain.
Should you really believe in the January effect?
Many market analysts argue that the January effect isn't any more reliable than any other seasonal indicator, and it's easy to find cases in which the indicator didn't work well. Just last year, for instance, stocks fell during January, and the S&P's small-cap index fell by the same 3%-4% amount as the S&P 500. Nevertheless, enough market participants believe in the phenomenon that it's worth knowing about, as the January effect can become a self-fulfilling prophecy if enough people follow it.
The best strategy is to use indicators like the January effect to buy stocks that you'd already want to buy anyway. That way, even if the indicator doesn't work the way you'd hoped, you'll still have a solid long-term investment that you want in your portfolio. In the end, that's a much better method to help you meet your financial goals than hoping for a quick short-term score from a possible month-long bounce that might not happen at all.