The outperformance of stocks in January has been linked to the divestiture of assets that have performed poorly and year-end tax-loss selling, but investors may face a different market in 2017.
Equities have often outperformed in January with investors utilizing their year-end bonuses and the proceeds from the sales of their underperforming stocks.
"The well-known 'January effect' refers to the stocks' superior returns during January," said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla. "Both retail and institutional investors tend to realize the capital loss of the losers to offset the realize capital gain of the winners."
The higher returns in January can be attributed to the lower stock prices in December stock prices as well, which is why the 'January effect' is also referred as the 'December effect,' he said.
The January effect is more pronounced for small cap and value stocks, which are often the loss leaders. Over the time, this phenomenon has weakened. The January returns of the Russell 2000 have traditionally exceeded 2.5 times compared to the other months, but during the past decade, January's return has been at par with other months, Ma said.
For the 15 years when December's return fell by an average of 4%, the following January staged a rally of 2.2%. During the 15 years when December's return rose by an average of 4.85%, it was followed by flat January returns of 0.40%, he said.
Election years have also affected January's returns. During the past seven presidential elections, four of the seven January returns fell by an average 6% while the other three positive January returns averaged a tiny gain of 0.50%.
Some experts believe the January effect already occurred in the aftermath of the election.
"Since November's Election Day, the stock market has risen around 10% across the board without any significant fundamental news," he said. "For all practical purposes, the 2017 January effect, if any, has most likely already happened."
Nearly all the gains of small caps are completed by March, said Matthew Tuttle, portfolio manager of the Tuttle Tactical Management U.S. Core ETF in Stamford, Conn. The election appears to have pushed the January effect earlier because of the hope of reduced corporate taxes which will help profits due to lower effective tax rates.
"The bottom in relative performance was November 3 instead of the normal first week of December," he said. "In fact, most of the outperformance this year, which was 10% versus about 19% happened between November 3 to December 9. We may not have a January effect at all this year because it basically has happened."
Although small cap stocks should benefit more than large cap stocks in the near term, the January effect will have less of an impact due to fewer investors who will accept losses for tax purposes due to the expectation for a better tax structure under President-elect Donald Trump, said Michael Berger, a former Raymond James energy analyst and founder of Technical420, a Miami-based company that conducts research on cannabis stocks.
Companies Which Can Outperform Market
One company who is likely to outperform the market is Canabo Medical (CAMDF) , because the Canadian company received an $8.4 million investment at a 60% premium to its current price, he said. "We also expect to see companies like OrganiGram (OGRMF) and Emblem (EMMBF) to outperform their peers on account of the improving fundamentals, the upcoming legalization of recreational cannabis at the federal level and the attractive valuation," Berger said.
"Companies levered to the emerging legal cannabis industry are expected to significant growth throughout 2017 as a result of favorable legislation," he said. "During 2017, investors will be able to capitalize on new growth opportunities like the Green Organic Dutchman's upcoming initial public offering.
Reliq Health Technologies (RQHTF) , a Canadian healthcare technology company, could also outperform the market during the first quarter of the year because of its four major pilot programs.
"We are bullish on the health care sector and expect Reliq to announce some significant catalysts during the next year," Berger said.
Instead of focusing on the January effect, which has only occurred 50% of the time during the past decade, including 2009, 2010, and 2014, investors should examine market fundamentals, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla.
"When the S&P 500 was negative in January during those three year, it finished strongly by the end of the year," he said. "On the flip side, positive Januaries for the S&P 500 have preceded positive years 90% of the time since 1950."
In addition to investing in small caps, the municipal sector could "take a severe hit from any future individual and corporate tax cut plans which would put a damper on the benefits of tax-free vehicles," Ulin said.
The consumer discretionary sector could also benefit from improved employment numbers, advancing wage inflation and the potential for tax cuts, he said.
"It could be a significant tailwind with more individuals and families spending money from vacations to home improvement projects," Ulin said. "While the market appears frothy, there is still room to run for a positive 2017. We are waiting to see what policies Trump will implement which may have direct effects on the economy, jobs, taxes and the markets for 2017."
The market could see a rotation into some of the laggards, said Ron McCoy, a portfolio manager on Covestor, the online investing company, and founder of Freedom Capital Advisors in Winter Garden, Fla. One stock which could perform well is BHP Billiton(BHP) - Get Report , the Australian company with one of the world's largest resource plays including petroleum, iron ore, copper and coal.
"After spending the last few years heading lower, the stock has resumed an uptrend and currently trades around $35," he said. "If in fact there is a major push for infrastructure spending, we believe BHP should benefit given their array of assets including iron ore and copper. If 2017 is anything like 2016, then anything is possible. Given the run up since the election, it will be interesting to see how it unfolds and who the beneficiaries are."