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The 'January Effect' Investing Strategy Is Running in Reverse

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The December run-up to the fiscal cliff crisis has brought into question the strategy's application.

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Search "January Effect" and you will likely find a number of varying investing opinions, strategies, and explanations of what it means for the stock market. In my case, it has always meant crafting a year-end strategy to try to profit from the tendency of certain downtrodden stocks to "bounce" in the New Year after investors sold them off to harvest tax losses as the previous year came to a close.

The theory suggests that the additional supply of shares from investors selling to realize tax losses places additional downward pressures to share prices, adding to share price declines, and then when that supply/selling subsides (i.e. after the first of the year when investors are no longer selling for tax purposes), shares of some of these beaten-down companies will naturally rise as tax-related dumping abates. A large ball submerged under water comes to mind.

Enter January Effect 2013. Every year this "effect" has varying success, and each year's market environment can dramatically influence its relevance. This year, the fiscal cliff may have flipped this strategy on its head. Due to anticipated tax changes, investor behavior seems very contrary to normal years, bringing into question the strategy's application.

In light of the fiscal cliff, let's first examine stocks that performed poorly in 2012: Beaten-down companies like Research in Motion (NASDAQ:RIMM), Best Buy (NYSE:BBY), RadioShack (NYSE:RSH), JC Penney (NYSE:JCP), and Advanced Micro Devices (NYSE:AMD) come to mind for many active investors. Many downtrodden stocks did not experience declines into year-end. And in some cases, many actually "bounced." On its face, it appears that many investors delayed taking tax losses prior to year-end, and that selling pressures these companies would normally experience were being postponed. Perhaps investors were holding off dumping their losers until this year anticipating that the "value" of their losses will be larger due to proposed tax changes.

Another dynamic – shares of companies with shareholders who've experienced massive capital gains over the years became the very companies who experienced year-end selling pressure. The most written-about company seeing this reverse January Effect is Apple (NASDAQ:AAPL), as many analysts have pointed to investors selling shares at the end of December to lock in capital gains as a potential reason for part of the December sell-off of previous highs.

How to potentially play these dynamics? First of all, I'm watching companies that have had large capital gains in tandem with investors selling into year-end 2012 to lock in capital gains. These are my new "bounce" candidates. Secondly, I still have a list of "dead-stock-walking" type companies, but am now watching those stocks for potential early-year 2013 declines; I want to see if investors quickly turn to harvesting losses early in this New Year. As with any strategy, flexibility and an open mind are key.

The January Effect and other types of strategies are usually very short-term in nature and can result in varying successes. Interpretations of what constitutes beaten-down companies, timing, exits, and individual situations can wildly affect results. I'm well aware of the inability and struggle in quantifying such ideas, but am merely trying to highlight dynamics that may exist within the markets, trying to exploit them and find any small edge in a very difficult environment for investors.

This article by Ross Heart was originally published on See It Market.
No positions in stocks mentioned.
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