According to the EMH, prices reflect all known information and all new information is priced in almost instantaneously. So theoretically, what I’m going to show you shouldn’t even exist. Theoretically. But it does. Not only does it exist, it persists. And every year, it thumbs its nose at bow-tie wearing economic professors everywhere.
As you may have surmised from the title, I’m talking about ‘the January effect‘. That is, the relative outperformance of small-caps at year end. Almost all traders are aware of the phenomena and each year they implement different strategies to try and take advantage of it. Below you will find my strategy.
But before I get into it, I’d like to share with you the most popular ‘year end’ strategy. This was introduced by the KCBT in the 1980s. It involves buying a contract of the Value Line futures contract at the close of December 20th (or the next market day if that’s a holiday) and at the same time, selling a contract of the S&P futures. According to the KCBT, the trade should be closed on January 9th (or earlier if that is a holiday). Obviously the intention is to profit from the discrepancy which appears at year end by being long the Value Line (small caps) and short the S&P500 (large caps).
With the exception of only 3 instances, this market neutral strategy has been profitable for the past 24 years. Last year (2005) it actually produced the largest profit in its history - after 2004, when it produced the second largest losses in its history. If you’re going to implement this, note that since this strategy’s creation, the multiples of the futures contracts have changed. Now you will have to buy ten (10) VL futures for each S&P 500 futures to make it market neutral.
Although I play the January effect, my take on it is a bit different than KCBT’s method. As many things in life, the January effect is really in the eye of the beholder. By that I mean it depends who is talking and what they are looking at. Some, like the KCBT say use the VL index (since they list it), others say the general market (large proxies like Dow, Nasdaq, etc. rise at year end), while others say the small caps (Russell 2000) enjoy the outperformance. I define the January effect as the once-in-a-year event when the ‘baby gets thrown out with the bathwater’.
For this to happen, there have to be very motivated sellers. Their motivation can come from a variety of sources: tax loss selling, getting spooked, changing their minds, etc. Of course, all these reasons can combine together (that is what I want!).
So to put it in technical terms, I’m looking for massive overhead resistance. I want the longs to be screaming to get out. As well, I look at volume to complete the picture. If I see the price action crushing previous lows with large volume, my attention is piqued. Ultimately I’m looking for a crescendo of volume: with each new low a higher volume. This tells me that the low volume is motivating the longs to get the heck out of Dodge!
So that is one of the characteristics. But just because a stock is falling that doesn’t mean it is a year-end play. I whittle the list down to stocks that have a specific following. I want stocks that are in weak hands. Very weak hands preferably.
What do I mean? Well, lets take IPOs for instance. A recent IPO is in weak hands. Why? Because the security doesn’t have a well vested base of followers. The people who have probably bought it were pushed to do so by their local friendly broker. Who in turn was only pushing the darned thing to get his annual bonus check.
Another example of weak hands could be preferred shares. Why? Because the holders of preferred shares are usually retail. They want that dividend check every month. Maybe they need it for their expenses. This is also true for all income oriented securities. Because most people who buy them share are interested in a regular stream of dividends or distributions, they are risk averse and therefore they are weak hands.
Another example of weak hands would be closed-end funds. Why? Again, the story is one of retail holders. CEF are by far and wide the most retail security on the exchange. This group of holders will easily get spooked very easily and sell when they should buy and buy when they should sell.
There are more but that sort of gives you an idea of what I’m looking for. So basically it’s lots of resistance which means the stock has worked its way lower (either sharply or grinding slowly) which translates into unhappy longs. I prefer these longs to be retail or ‘weak hands’ because they will find solace at year end in that fact that they can sell their dogs as ‘tax loss’ and at least get something in return.
The strategy is to look for this sort of action and buy on an inflection point. To scoop up the ‘baby’ when it is thrown out with ‘the bath water’. I do this by focusing on securities with the above mentioned characteristics during the middle to end of December. Of course, I choose this time period not only because most people do their tax loss selling then but also because the yearly cycle is a natural time for investors to rebalance and prune their portfolios.
This strategy is a high probability play with around 80-85% accuracy. But unfortunately it doesn’t have that high of a return. I’ve found that a return of 5-6% is the best onw can expect, on average. For these reasons, I use a lot of margin when implementing this strategy. My hold time is usually only a few days but depending on the price action it can go up to two weeks or more. Eventhough that return might seem paltry to you, the annualized return is amazing. Which is why I go through the whole exercise in the first place.
ok enough theory! Let me show you what I mean with a few examples of trades I made last year. The green dot on the graph represents the buy and the red dot the sell. The first one is the Nuveen Florida Muni Fund (NUF):
As you can see it is a closed-end fund (check), it is a bond fund (check) but it is not a recent IPO underwater. So two out of the three criteria that I mentioned are present. Ideally we want as many as possible, but its not possible always. So we work with what we have.
Now take a close look at the chart. It doesn’t look so great… if you are long. Which most people are because of the nature of the beast. Now look at the volume at year end. As the price was screaming down the volume was getting heavier and heavier, reaching a crescendo of panic. That is what I watch for.
Now some practical things. Where should we enter? I always enter with limit orders since these things can be very tricky and illiquid (eventhough we are playing them at their most liquid time!). I watch for a couple of things. First, I want the volume to decrease and descrease dramatically. This tells me the sellers are finished. As you can see on the chart above this happened like clockwork and it signalled an end to the selling pressure. If that doesn’t happen, I watch for a small congestion pattern to unfold in the middle to end of December. This would tell me altough the sellers are continuing to sell, they are being met with an almost equal and opposing force: buyers.
Usually, I don’t buy my whole position at once. I scale in using nickel or quarter increments (depending on the price of the security). Through trial and error, I’ve found this is a good way to make sure that your basis is as low as possible. In the case of NUF (above) eventhough I scaled in, the whole position was entered on one day.
The exit; as I mentioned I only want 5-6% out of this. I’m not greedy. I begin to scale out at those levels. At the same time I’m mindful of technical resistance. I am not at all worried if volume is very anemic. I know that we are told that a receding volume and a rising price is a no-no. But in this case it is a normal occurrence and nothing to worry over. It is the result of the extraneous situation that is the January effect. As you can see on the chart, I exited ‘early’. But I don’t really care that the price continued to go up because I executed my plan.
If you are interested in some more examples, take a look at the charts below. They may not be exactly the same technical picture as NUF but each has certain elements that I mentioned. Remember we want as many things to align as possible. But we can’t have everything go our way!
I had a great entry on BYM (above) but my exit was way too early, as you can see. I should have scaled out over a few days.
The example above (BEP) shows why it’s smart to scale in over a few days. I thought I had nailed the low but then it went lower. Apparently the volume decrease I saw was just a pause. The real crescendo came a day later after my last buy and from then on, volume decreased while price inscreased. Just as I expected.
I was very lucky with ERC (above) since I almost got in at the very low. But then I scaled out a bit soon. I didn’t really like that long wick at the top of the long range bar.
ETB (above) was an IPO that had gone under water from its issuing price of $20, leaving a lot of unhappy longs. It also presented a good example of the congestion I mentioned above. While volume was building like mad, price got into a tight range. This was a sign that the buyers were as aggressive as the sellers. Again, in hindsight, I can say that I got out too early. But scaling out allowed me to get a faily good average exit price.
I was quite lucky with JLA (above) too since I got in at the very low. You might be wondering how I did that. I looked at the volume! I knew during the day that volume was on course to break all the previous day’s record. This was the tell I used. Of course, I could have been wrong. But in this case, it worked like a charm. And again, like a broken record, I have to say that I did get out too early. But I was executing my plan and it is of no use fretting about such things when they are obvious in hindsight.
The entry for EOI (above) was also triggered based on the high volume that day. As you can see, it was the highest volume reading for a long time. I also bought at the $18 level because of the small congestion that had occurred there for the past few days. Eventhough prices did dip slightly lower, they recovered and went on to zoom higher. I exited in two batches. In hindsight, I should have sold at the resistance level at $19.50 (where in Sept-Nov price had bounced off it as support).
The chart of JPG (above) shows graphically what I’ve described in the method above. The security was issued on November 23rd 2005 at $20 and not much later, it cratered. Remember, this is a security that people have bought for income, not speculation. As you can imagine, the lower it goes, the more they sell. Until it is gapping down hard during tax-loss season. Evenso, I didn’t take advantage of JPG to the fullest. My entry was a bit too early. The heavy volume dropped off but price continued lower. Unfortunately, I didn’t take advantage of the drop in subsequent days to scale in more to lower my basis. Also, my first exit was sloppy and way too early. My second exit though was based on the gap on the chart and it was alright.
ECV (above) was another nuked IPO. The entry was based on the volume tell: being on track to trade an unusually high amount. After my entry, price entered a congestion and thrashed about while volume subsided - except for the last day of trading in the year. After that, price continued to rise with anemic volume. I scaled out over a few days and didn’t overstay my welcome.
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