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15 Reasons For a Larger Than Normal January Effect


Watch these factors at the end of December into January...


Wikipedia's brief definition of the January Effect is below:

The January Effect (sometimes called "year-end effect") is a calendar effect wherein stocks, especially small-cap stocks, have historically tended to rise markedly in price during the period starting on the last day of December and ending on the fifth trading day of January. This effect is owed to year-end selling to create tax losses, recognize capital gains, effect portfolio window dressing, or raise holiday cash. Because such selling depresses the stocks but has nothing to do with their fundamental worth, bargain hunters quickly buy in, causing the January rally. The Incredible January Effect by Robert Haugen in an authoritative text describing the January effect.

I have a more flexible view/definition for the January effect, though the above hits most of the key points. Mainly, that a lot of selling is structural and not fundamental. Related to timing and duration, sometimes the effect starts earlier and as far as just being a multi-day move, I would not necessarily agree. I would say the the timing can start from the last couple of weeks of December and can run into the Jan. EPS reports for many afflicted stocks. Below, I've listed 15 reasons why this year's January Effect might be a bit larger than normal:

1) The volatile market this year has experienced wide swings both up and down, creating many more opportunities than a normal year for investors to take gains. Larger than normal gains has created greater impetus to sell losers before year end.

2) Extreme pessimism in the small cap space is creating a spiral effect. Fundamentals have ceased to matter, thus exhibiting a capitulative effect in many names.

3) Short Covering, Part I: Elimination of the downtick rule as well as levered ETF's have made it easier to press the weakness in these names and I believe many quants have done just that. Shorting lower cap higher beta while buying larger cap lower beta, regardless of valuation. That works until it doesn't anymore and a turn in many names could actually start with very little money behind the buying.

4) Short Covering, Part II: In conjunction with the above, short interest in many weak sectors/names is at or near all time highs, public short sellers have been especially aggressive.

5) Hedge fund redemptions are reported to be running higher than normal. Many of small/mid cap names were/are considered deep value as well as activists longs.

6) Volume in this area has been well below normal of late so the selling has not been due to fundamental breakdowns. Just a dearth of buying.

7) Many of the most beaten down names/sectors have the best balance sheet fundamentals (even select finance stocks). High cash per share and low or no debt.

8) Likewise, many also have little to nothing to do with the weakest financial sectors.

9) M&A activity will continue to be strong. Several names that would have been excellent Jan. effect trades have been acquired in the last few weeks. Nextest Systems (NEXT), Saifun Semiconductors (SFUN), Genesis Microchip (GNSS), and NetManage (NETM)

10) Analyst coverage has been as negative as I've seen in small cap, especially in light of relative growth outlooks. Regardless of strong recent quarters by many, coverage has been negative or nonexistent, earnings forecasts have been reduced and even the bullish analysts have their foot halfway out the door, issuing cautious projections and targets.

11) Repeal of or adjustments to Sarbox for many smaller public companies appears to be in the works and is being endorsed by both political parties currently. These costs do hit smaller companies to a greater extent and relief from these costs would increase net earnings and earnings growth.

12) Earnings comps should be easier going into 2008. Stock option backdating issues as well as a few other items have greatly reduced GAAP EPS, all the while, cash flow and other growth metrics have stayed inline or improved.

13) Very little media coverage has been given to the strength of this underlying bear market, while strength/stability of the index averages are masking the real damage taking place under the surface. However, I believe this is a key reason why investor sentiment and many other fear gauges have been registering high readings for sometime.

14) Even though the market has reacted negatively thus far, 100 bps of easing has been infused into the system. After the tax loss and window dressing are largely completed for the year, investors will be looking for companies that will benefit from these lower rates. Moreover, these lower rates will have a more pronounced effect and less lag time in areas that have undergone less economic damage.

15) USD is starting to strengthen (see the chart below). Foreign buyers of US stocks and the currency kicker can boost returns by buying beta. This beta buying should fuel money flow to the small/mid-caps. This could exacerbate the upside move as not nearly the kind of capital is required to generate significant moves in many of these really beaten up names. Essentially, this is just the inverse of the beta trade described above and could really hammer the sellers of high beta.

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