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12/21/2012 4:00:00 PM
The " January Effect " is a well-knownmarket phenomenon famous for causing the stock market to rally during the month in most years.
It's considered an anomaly because it's not driven by the market's forces. A widely agreed-upon explanation around this event is that investors sell stocks at the end of the year for tax reasons and reinvest again at the beginning of the year. Another famous explanation is that investors use themoney they earned in bonuses to invest, typically at the first of the year.
Since 1950, the market has posted more gains in January than it has posted losses, so investors have come to expect a positive performance at the start of the year.
Take a look at the chart below....
Many investors are expecting an even bigger upside this year as uncertainty over the "fiscal cliff" subsides and economic data begin to improve in other parts of the world. Headlines of private meetings between President Barack Obama and Republican Speaker of the House John Boehner have already pushed stocks up 6% in the past month and as investors expect even higher prices into the New Year.
But these investors could be in for a shock come January 2013.
Two very powerful and unavoidable forces could send the market down in January, so investors should prepare their portfolio.
The January effect, reversed
This leads to selling pressure and underperformance particularly in the small- and mid-cap market through mid-December and an outperformance in January. January returns of the S&P 1500 have outperformed the larger companies in the S&P500 by an average of 5.9% during the past four years and the demand for stocks after the December selling generally brings the overall market up as well.
This dynamic may have changed with the prospect for higher tax rates next year. With highertaxes coming next year for at least some income groups, investorswill want to pay as much of their capital gains at current rates and hold off on selling their losers until next year. This could lead to less-than-expected selling pressure this December and less rebound demand in January.
If that were the onlyissue facing January's market, then I might be a little more optimistic.
A fiscal cliff deal, but now what
Even a compromise will still take away about 1.5% of annualized gross domestic product during the first quarter as a result of some fiscal policy expirations. Along with other likely spending cuts and tax increases in a resolution, there is no denying the fact that theeconomy will face a fiscal headwind in the first half of next year.
How to protect your portfolio
Large company bellwethers with strong fundamentals should hold up well through any market turbulence. Stocks to position for protection are the old favorites such as Coca Cola ( KO ) with its strong brand loyalty and 2.7%dividend yield . Compared to its peer group, pharmacy and retailer CVS Caremark ( CVS ) trades for a relatively low 16 times trailing earnings and pays a 1.8%dividend . The pharmacy side of the business is strongly supported by the flu season in the short-term and by a growing aging demographic in the long-term.
Investors who don't want to sell their positions, but want to protect themselves against market disappointment might look at a basket of stocks such as theexchange-traded fund ( ETF ) ProShares Short S&P500 Fund ( SH ) which moves up when the generalindex drops. I like thisETF because it gives investors a chance to take an insurance position on the market against their stronger individual stocks without having to get into options or short-selling.
Risks to Consider: Any time an investor tries to time the market with a horizon of less than a month, the risk is that the thesis will not play out. Investors should use the information as a warning to not get overly exuberant about a possible January run and not dramatically change theirinvestment strategy in hopes toprofit from the January effect next year.
Action to Take --> Blindly taking a position ahead of the January Effect this year could lead to unexpected losses as new tax laws reverse the normal scenario. Investor sentiment could also turn negative because of fiscal hurdles ahead, which would also lead to a weaker market performance. Investors should position their holdings more conservatively and protect their gains while waiting for a better market toward the end of the first quarter next year.