Trader’s Narrative

Last month I outlined a strategy using closed end funds to take advantage of the January effect in the stock market. The opportunity came and went, so here’s a brief review with a few specific examples.

In order to give you the right idea, lets start with a good example to show the pattern we’re looking for. The BlackRock Minicipal Bond Fund (BBK) is a great example of the setup:

Notice how it dropped right into the technical support previously found in mid October? That, along with the volume spikes in early December, make this a great example. As prices lifted off into the new year, it was attracted to the swing high which acted as resistance - making it a natural place to scale out (red arrows).

Here’s another example with an equity CEF, the RMR Dividend Recapture Fund (RCR):

I’ve highlighted the low volume because can be problematic if you step in with size and don’t use limit orders. Otherwise you’d do fine and pocket a +60% return. Even if we assume that you were able to squeeze out half of that, considering slippage and trading costs, etc. you are still looking at an astronomical annual rate of return.

Finally, I also wanted to show a less than perfect example to make sure that you don’t mistake this strategy as a sure thing:

I stayed away from this one because it isn’t a municipal bond fund but if you played it, it was difficult to come out unscathed. On the plus side, the loss was very small. But it serves as a reminder that even with a high probability setup like this one, you can’t ignore risk completely.

If you want to see even more example, take a look at My Year-End Strategy.

The beginning of the year is a special time that rightly attracts much attention. The January effect is mostly over by now and hopefully you were able to trade this phenomena profitably. It is too bad it only comes around once a year.

There are a few other similar patterns for January. Probably the best known is “as January goes, so goes the year”. Another says that the first 5 trading days determine the market’s returns for the whole year ahead. And another says that how January performs predicts the direction of the market for the remaining months of the year.

Mark Hulbert showed a few days ago in this column that the 5 first trading day pattern simply isn’t true. In fact, the only one that does have validity historically is the third one listed above. The January Barometer says that the performance for the first month has a predictive quality for the returns generated between the second and twelfth months.

Because of the positive bias of the market, this indicator works best when it predicts a bullish scenario for the remaining 11 months of the year. From 1940 to 2008, January’s return was positive 43 separate times. Of these, 86% of the time the next 11 months were also positive. On the other hand, in only 40% of the cases when January was negative was the rest of the year also negative. The overall accuracy of the January Barometer within that time range was 73.9%.

So with an almost 75% historical accuracy rate, we’ll have to wait until the end of this month to see what it augurs for the rest of the year.

Below is a look at the raw data from 1940 to 2008:
Continue reading ‘The January Baromoter’

There a few ways to take advantage of the January effect this year:

Small & Micro-Cap ETFs
The simplest would be to buy small cap stocks or ETFs before the year end and hold until they have a pop. Since the definition of “small-cap” has been continuously revised up over the past few years, it might be a good idea to look at “micro-cap” stocks. Here are a few ETFs:

• iShares Russell Microcap Index (IWC)
• First Trust Dow Jones Select MicroCap ETF (FDM)
• Powershares Zacks Micro Cap Portfolio ETF (PZI)
• Powershares Dynamic OTC Portfolio ETF (PWO)
• iShares S&P SmallCap 600 Index Fund (IJR)
• iShares Russell 2000 Index Fund (IWM)
• iShares Morningstar Small Core Index Fund (JKJ)
• SPDR DJ Wilshire Small Cap ETF (DSC)
• Vanguard Small-Cap ETF (VB)
• PowerShares Dynamic Small Cap Portfolio (PJM)
• PowerShares Zacks Small Cap Portfolio (PZJ)

Closed End Funds
Last week I mentioned a method to capture January effect alpha which uses CEF and specifically, municipal/bond CEFs. This year is a bumper crop for this specific strategy because of the vast number of these funds which have severe losses.

Value Line Futures Index
Yet another way to play the January effect is to use the Value Line Arithmetic Index futures. This is a little known equity index compiled by Value Line Inc. - the investment research outfit. It is comprised of approximately 1,650 stocks which are equally-weighted, as opposed to capitalization weighted as in the S&P 500 Index.

The futures for this index are traded at the Kansas City Board of Trade with each contract valued at $25 times the value of the index (appx. 1324). The Value Line January effect strategy is pretty straight forward:

Buy the Value Line contract (nearby month of course) and (sell short) equal value ratio of the S&P 500 Index. Close the position in the first week of January. Depending on the calendar, around the 9th of the month. That’s it.

This simple spread trade has a remarkably high profitability ratio but sadly it only comes once a year. And the advantage it has to the other two year end strategies is that it is market neutral. Although I suppose you could short SPY to offset a long position in small/micro-cap ETFs.

As this annus horribilis draws to a close, we are left ducking shoe after shoe that drops or is flung at us. But this year’s abysmal performance has a silver lining. It offers a sumptuous buffet for those who finish off the year with a play on the January effect.

For the novice, this is the trading pattern at the end of the year which the efficient market hypothesis says shouldn’t even exist. Usually it is small or micro capitalization stocks which have declined and are then pushed down further by tax-loss selling. The opportunity is to play these for a short term bounce into the new year.

Personally, I focus on closed end funds (CEFs) and within them usually fixed income or municipal bond CEFs. I go into great detail explaining the background, rationale and several actual trades: My Year End Strategy

I won’t repeat myself because you can get all the info you need from the above link. This is a very high return, high probability trade but it depends on how poorly the target securities have fared.

This year, I feel like a kid in a candy store. While this abundance is great, it does make it a bit more challenging to filter all the potential plays and find the best ones.

You can sift through the CEFs through a publication like Barron’s which not only prints their prices but also their year to date performance and premium/discount to NAV. Online you can use the CEF Association’s database or check out ETF Connect and use their Fund Sorter or do an advanced search to only look at certain sub-sections of securities like municipal bond fund CEFs.

Here’s an example of the sort of securities to choose from:

Continue reading ‘How To Play The January Effect This Year With CEFs’

Forget everything you know about the market. If you have a long enough time horizon, all you need is a calendar.

More specifically:

1. Look at the calendar
2. From May to October, stay out of the market (or go short).
3. From November to April, buy or go long.

That’s it.

Forget technical analysis. Forget fundamental analysis; watching talking heads on TV; reading blogs (cough). Or anything else.

The only catch is that you have to have time on your side. Because each and every single instance is not going to go in your favor. But on average, you’ll be far ahead of a simple buy and hold strategy.

For some strange reason, winter months are great for stock market returns and summer months are bad. This holds true across time as we go back decade after decade, it also holds true if we go across the globe and look at different stock markets in different countries.

This is known by a few names: Sell in May and go away, Halloween indicator, winter months good, summer months bad, etc. Theoretically this pattern should not exist. But it does. And it bothers a lot of economists. Most of them would rather not think about it so they just shoo away this and similar holes in the EMH.

Fact is that the Halloween indicator, like election year pattern, the January effect, 4 year cycle and many others, present not one but two challenges to EMH. One, they should not exist if the market is as economists theorize, “efficient”. Two, if they did exist, they shouldn’t persist, which they do. That is to say, if they do exist, which they shouldn’t in the first place, they certainly shouldn’t continue to exists year after year, decade after decade because theoretically, people would wise up and by taking advantage of it, remove it from occurring.

Neither of these is true, of course.

Probably the definitive report on this anomaly was published Ben Jacobsen and Sven Bouman. You can read their working paper from July 2001 in the free trading resource section (Reports & Articles).

They not only look at the pattern of stock market returns, they turn over every stone looking for an explanation. They can’t find any. But they do have some interesting things to say nonetheless:

Based on the old market saying Sell in May and go away (or the Halloween indicator), we find that there is a substantial difference between returns in the period May-October and the remainder of the year. In fact our evidence shows that while during the period November - April returns are large in most countries, average returns in the period May-October are not significantly different from zero and are often even negative.

We found that in many countries the Sell in May effect cannot be a January effect only.