January rally too hard to call

The January effect, the well-known historical phenomenon where stocks (particularly small-cap ones) rally in the wake of a buying spree from last year’s tax-loss selling, has many perplexed this year. In most years, it’s a fairly dependable phenomenon, but recent market conditions have bucked trends rather than followed them, leaving the prognosis for a January rally a complete boondoggle.

Money managers will have a lot of cash on hand, as tax-loss selling is anticipated to be huge this year. Unless there’s a widespread belief that markets have hit bottom, it’s hard to predict whether they would be willing to deploy that cash immediately into riskier high-growth potential assets.

Merrill Lynch thinks there is a likelihood of the January effect, particularly in the asset classes that have been ravaged the most by the bear market. For instance, Richard Bernstein, chief investment strategist at Merrill Lynch, thinks there is a good chance there could be a rally in C&D grade bonds.

Investors may have attempted to anticipate the January effect in recent years. Prior to this decade, C&Ds tended to underperform A+ (rated) bonds in the fourth quarter nearly two-thirds of the time, and the average January effect outperformance was about 7.5 percentage points,” he writes. “However, that tendency for fourth-quarter underperformance has reversed, and C&Ds have outperformed A+ bonds nearly two-thirds of the time in the fourth quarter since 2000.”

Bernstein notes the performance of C&Ds has drastically lagged that of higher quality bonds in the fourth quarter of this year, meaning this asset class might get a shot in the arm from investment managers looking to deploy capital in beaten-down sectors. Typically, January buying goes into riskier assets, viewed by managers to have had the steepest decline in valuations, and therefore the greatest likelihood of growth potential.

“C&Ds are underperforming A+s by approximately 23 percentage points. Historically, this implies about an 88% chance of a January effect in 2009. When C&Ds underperform A+s during the prior year, the average outperformance is 5.2 percentage points higher during the subsequent January than when they outperform during the prior year,” Bernstein says.

In a comprehensive study of small-cap stock performance released Monday, Steven DeSanctis, chief small-cap strategist at Merrill Lynch, says historical data would indicate stocks worth less than $5 a share could be poised for a big bounce.

One of the reasons for this is simply that there are now more stocks at these low valuations than there have been for quite some time.

“With the drop in stock prices this year in the Russell 2000, we have seen a significant number of names now trading at single digits. In fact, just over 29% have prices less than or equal to $5, and another 22% trade between $5 and $10. A number of concerns regarding these stocks have surfaced of late from our clients,” he says. “First, some institutional investors are unable through client restrictions to own or buy stocks below a certain price threshold. Also, when the market has bounced, these stocks have tended to lead the way, and without much exposure to these names, active managers may trail their respective indexes.”

DeSanctis says historically these stocks get a push in January, but then tail off in long-term performance. However, during other near-catastrophic drop-offs in market performance, some names have exhibited phenomenal returns over a sustained period of time.

“There were a few periods similar to today, in which stocks under $10 hit an unusually high level. We found three periods very comparable to today and of course they also coincided with market lows. The three periods were November 1987, October 1990, and February 2003,” he writes. “We then measured the subsequent performance of the Russell 2000 and found returns were much higher than average. For the subsequent three months, we saw very similar returns for all three time frames, with the average coming in at 22.5% versus an average three-month rise of 3.2%.”

Of course, not all cheap small caps did well. Generally, stocks with undervalued price-to-sales ratio and low debt-to-capital ratios fared better. Companies with low debt-to-capital saw their spread in 12-month performance increase to 12.3% during the three selected periods.

“Some of the characteristics were intuitive just based on the performance patterns. One would have expected high-beta stocks to work, and they did, along with lower market caps and weak relative price strength scores,” he wrote. “We also found that valuation factors tended to work during these three periods, as the cheapest names based on price-to-book, price-to-sales, and forward P/E all posted positive Q1/Q5 spreads. The price-to-sales ratio had the best results over the subsequent six- and 12-month time frames. We also saw that high levels of cash relative to market cap were a very strong factor, with the Q1/Q5 spreads all above 10% for the three time frames.”

Utilizing a January effect strategy is still a risky proposition, and one that is highly oriented toward short-term performance, says Bob Gorman, chief portfolio strategist for TD Waterhouse.

“Investors are going to have very large cash holdings come January and there is a good possibility they could be buying,” he says. “Frankly, investing based on that short-term indicator is fraught with peril.”

Gorman adds that bad economic news or important market developments can easily overwhelm any trend by managers to add risk to the clean investment slate the new year brings.

“It could be the price of oil. It could be retail sales numbers in the wake of the Christmas selling season. It could be numerable factors that could more than offset a short-term seasonal factor. It’s not something I would really bank on as an investor,” he says. “Oil is trading at about $40; that would overwhelm any seasonal factors as they pertain to the Canadian market.”

(12/24/08)