Tales of a Technician: The January Effect
December 28, 2021
In last weekend’s Options Report, I highlighted the bullish history of the Santa Claus rally. Today I’m continuing the seasonality focus with a look at the January Effect.
To set the stage, it’s important to put seasonality in context. Recall that as technicians, our job is to stack the odds in our favor. We do so by looking at the weight of the evidence. This stands in contrast to anchoring on a single data point for our decision-making. Logic suggests that the more evidence supporting a particular forecast the better.
For instance, consider which backdrop you’d rather have for buying stocks:
- The S&P 500 is in an uptrend. The Federal Reserve is engaged in easy money policies. Corporate profits and margins are at record highs. We’re entering the most bullish time of the year.
- The S&P 500 is in a downtrend. Monetary policy is tight. Corporate profits are stagnant and margins shrinking. We’re entering the most bullish time of the year.
Obviously, the first is most compelling.
Seasonality is simply one additional data point you can consider when surveying the market landscape to determine your bias and find trade ideas. I never place a trade based on seasonality alone. Instead, I use it to complement the other facets of technical analysis.
If you don’t want to search Google for all of the various seasonal patterns that have been recorded and popularized, I suggest buying a copy of the Stock Traders Almanac. It’s updated annually and is widely considered the bible for all things seasonality.
The January Effect
The January Effect refers to the tendency of small caps to outperform large caps throughout the month of January. However, the phenomenon tends to begin around mid-December. Here’s a ratio chart of small caps to large caps that illustrates:
If you’re unfamiliar with ratio charts, when the price in the numerator (small caps, in this case) rises faster than the price in the denominator (large caps), the ratio rises. Note how there’s a sharp rise in the chart from Mid-December through the end of January. This reflects small caps outperformance, and its arguably the most prominent part of the entire chart.
On a side note, the chart covers 1979 to 2012. I was unable to find an updated graphic, but the overall seasonal pattern hasn’t changed much.
By definition, small cap stocks include companies with a market capitalization below $2 billion. I use the Russell 2000 Index (tickers: /RTY, RUT, IWM) as the proxy. Large cap stocks include companies with a market capitalization above $10 billion. I use the S&P 500 (tickers: /ES, SPX, SPY) as the benchmark.
I’m going to use Dec 20th as the starting point since stocks formed a significant pivot low on both indexes. Since then, SPY is up 5.6% and IWM is up 6.6%. Three things to consider.
First, small caps have outperformed large caps during this climb. But, given the higher volatility of small caps, they usually tend to see relative strength during risk-on rallies.
Second, it’s too soon to pass judgement on whether the January effect played out this go around.
Third, if you want to place a trade based on the January effect, then there are multiple ways you can do it. Perhaps the easiest is to build bullish trades on IWM for the next month. Presumably, you would be doing this in lieu of bull plays on SPY as a way to favor small caps over large.
Given the sloppy mess that is IWM’s price chart, I’ll be rooting for some strength. It will be nice to get a bona fide uptrend back in this puppy.
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