Friday, December 12, 2008

The January Effect After Really Bad Years In Stocks

From World Beta:
2008 is shaping up to be a terrible year for stocks with most indices down around 40%. It doesn’t do any good to worry about what has happened, but a better question is: what can I do now?

While our flagship model is a very simple trendfollowing system, I spend a lot of time thinking about other systems based on structural or behavioral phenomena. One well documented effect is the historical outperformance for small cap stocks in January. A simple system of holding the smallest 20% of stocks every January since 1927 results in returns of around 10% a year (and that is without sitting in cash the remaining 11 months of the year which would add an additional 3.5% per annum to returns). That dwarfs the 1.5% return for the largest 10% of stocks in January.

Below is a table of the smallest 10% and 20% of stocks vs. the largest 10% and 20% of stocks in January. (I am using the French Fama data.) Note, if you employed a market neutral strategy (long the small caps and short the large caps -denoted “hedged“ in the table), the returns would still be very respectable with zero market exposure. The table excludes the approximate 3.5% per annum cash return the remaining 11 months.

The below chart adds in cash returns to compare investing in the January small cap strategy vs. investing in the S&P 500 total return....MORE