Playing the "January effect"

Mon Jan 9, 2012 2:33pm EST

A taxi is driven on a snow covered road in downtown Montreal, January 28, 2010.   REUTERS/Shaun Best

A taxi is driven on a snow covered road in downtown Montreal, January 28, 2010.

Credit: Reuters/Shaun Best

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(Reuters) - For years, one of the more bankable phenomena in finance has been the January effect.

The premise is simple: Institutions and traders sell off stocks the end of the year for tax reasons and portfolio dressing. Then they start buying again in January, often favoring small companies, also known as "small caps."

With myriad signs that the U.S. economy is in recovery, this may be another good year for the January effect. Even if it isn't - and I refuse to make predictions for short-term traders - it would be a good idea to add bargain-priced small caps to your core portfolio through index mutual funds or exchange-traded funds (ETFs).

While there's certainly some controversy about whether the January effect is legitimate since its "discovery" in 1942, there are behavioral reasons why it may exist. Many investors like to clear out their deadwood by the end of the year and start afresh in January.

Instead of adopting new resolutions, they buy stocks. That's one theory, anyway. Since 1991, the average January return on the S&P 500 Index has been 6.7 percent.

Another view is that after a holiday respite, investors are looking for new, profitable ideas. Since last year's stock market, as measured by the S&P 500, was virtually flat, it's understandable that investors are hoping for a change of pace and a robust January may set the tone for the rest of the year.

JANUARY EFFECT HARBINGER

Since institutions, which dominate the market, migrate from category to category like sheep in a field, they may shift from once-favored stocks - such as large companies - and move into small caps. Is this happening now?

In just one ETF - the iShares Trust Russell 3000 - we get a snapshot of what may be happening. In just the first day of trading this year, the fund shot up 2 percent.

Is this a harbinger of things to come? It's impossible to say, but it's plausible to think that small-caps may be the leading edge of winning category this year.

Similar results were posted by the Schwab Small-Cap ETF . For the week, the stock market was up about 1 percent, tugged at both ends by upbeat employment and continuing euro zone angst.

Overall, there's a hint of optimism in economic news in 2012 that was reflected in widespread market gains. U.S. manufacturing and homebuilding have perked up and job creation is on the rise.

PLAYING THE EFFECT

If there's a prolonged economic and sustained rebound afoot that favors most stocks, here are some ETFs to consider as long-term holdings:

* Vanguard Small Cap Growth ETF. Following a basket of more than 1,000 small companies, this is a good, low-cost way to sample this category.

* SPDR S&P 600 Small-Cap Value. Like the Vanguard fund, this ETF tracks an index of small companies, only with an emphasis on bargain-priced stocks.

Don't make the mistake of getting into these funds and bailing at the first sign of trouble. The last few years have not been kind to small caps in general and we're certainly not free and clear of any potential economic potholes. And one week doesn't foretell what will happen the rest of the year. That trap ensnares a lot of investors. Past returns don't guarantee future profits.

You should plan for the kind of future you can control. Hew to an investment policy statement - draw one up that states your personal financial goals - instead of trading based on short-term moves. If you make only one resolution this year, that's a solid one.

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The author is a Reuters columnist. The opinions expressed are his own.

(Editing by Chelsea Emery)

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