January Effect May Be Poised for a Comeback

Tax-loss selling in a bad year for equities and worries about investor behavior at the turn of the year could prompt a January bounce-back for small-caps.
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Around the time people begin to recognize a pattern to something on Wall Street is usually when it begins to break down.

Take the January effect, that bump that underperforming small-caps are supposed to get at the beginning of the year. The theory behind it makes good sense. At the end of the year, individuals and fund managers give the worst-performing stocks in their portfolios the boot so they can register the loss on their taxes. This selling, in turn, depresses prices further -- particularly in smaller issues, which don't have as liquid a market. Once this tax-loss selling abates, the stocks catch a bit of a rebound.

Or at least that's the way it's supposed to go. The problem is that as more and more people figured out the phenomenon, the less of an effect it had. Tax-loss sellers found ready buyers among those who were trying to take advantage of the effect earlier. Those buyers, looking for just a short-term pop, were sellers in January.

Other problems developed. More mutual funds' fiscal years end in October these days -- nearly as many as operate on a calendar year. To that, add the effects of big large-cap gains. In recent years, those shares that were sold for tax purposes haven't found too many ready buyers in January, as underperforming managers who held them were quietly called into their bosses' offices and told to index ever-greater portions of their portfolios to the

S&P 500

.

Lately, however, there's been talk of the January effect returning in all its former splendor. It has been a bad year for most stocks. Of the 1,500 stocks in the S&P 500, the

S&P MidCap 400

and the

S&P SmallCap 600

, more than 60% are down on the year. More than 60% are trading below their 200-day moving averages. Half are down more than 10% this year. More than 60% are over 20% off their 52-week highs.

Notes Donald Keim, a professor of finance at the

Wharton School

of the

University of Pennsylvania

who has done extensive work on the January effect, "There definitely seems to be some relationship between the magnitude of it and how poorly stocks have done in the previous year."

Y2K Raises Liquidity Worries

Moreover, there is concern that investor behavior at the millennium change may intensify the year-end selling of losers. Steve Kim, equity derivatives strategist at

Merrill Lynch

, says that a number of institutional clients he's talked to are "worried about liquidity effects" of Y2K. "In general, the perceived risk is what the retail investors are going to do when they need to take tax positions and at the same time raise cash" to have on hand in case of any Y2K disruptions, says Kim.

Even without the worries about tax-loss selling, small-caps wouldn't be the most attractive issues these days. For one thing, investors worried about Y2K are likely to view diversified companies as safer bets than ones with limited revenue streams. And

Morgan Stanley Dean Witter

equity strategist Peter Canelo points out that rising interest rates "are always a negative for smaller companies." At least until the

Federal Open Market Committee

meets on Nov. 16, investors are unlikely to have much confidence on that front, today's

ECI

-driven rally notwithstanding.

The worries over liquidity mean that any shares put on the market by funds whose fiscal year ends tomorrow won't necessarily find ready buyers until the market gets past its bogeys.

The funny thing is that a lot of these worries weighing on small-caps could very well come to naught. Though they may not be diversified, the large portion of most small companies' business is domestic -- and it seems increasingly unlikely that there will be any large Y2K disruptions in the U.S.

Institutional worry about retail investor behavior, too, seems overdone. Keim thinks that if individual investors are going to sell shares at the end of the year, "they'll sell for economically related reasons," not because of Y2K. Moreover, the retail investor has not been very active in the small-cap arena in recent years, concentrating instead on growth funds and growth stocks.

Not that that matters -- fear does not need to be well founded to send stocks lower. What does matter is that if we get through New Year's without computers melting, planes falling out of the sky and the requisite plague of frogs, small-caps could be in for a nice bounce. "There's a lot of things holding them down," says Canelo, "and my guess is that those things are going to be looking better by the beginning of the year."