Ramblings of a Portfolio Manager 12-7-2009

Ramblings of a Portfolio Manager or It’s December, Time For The January Effect

The so-called January Effect, observed since the 1920s but not academically recognized until the 1980s, describes the phenomenon where the equities of small companies (small-cap stocks) tend to not only increase in price but outperform the stocks of larger companies in the month of January. Much scholarly research and speculation have been directed at the anomaly with the most commonly accepted explanation now being that year-end tax-loss selling pressure of less liquid securities, which small-cap stocks tend to be, is reversed in the new calendar year when those same securities are re-purchased by investors. This rationale seems quite intuitive except for one small quirk: Wall Street, in its never-ending search for profitable advantage, has front-run this somewhat reliable observation and in the process moved it from January to December or even earlier. So while the original motivation behind the effect may well have been taxes it has, of late, become a self-fulfilling, self-sustaining prophecy of sort.

The January Effect (really now the December Effect) doesn’t always manifest itself but tends to be fairly consistent and we observed it even during last year’s financial market meltdown when the Russell 2000 index of small-cap stocks rose 5.8% in December versus 1.5% for its large-cap brother, the Russell 1000, and a small decline for the Dow Jones Industrial Average. It’s no surprise, then, that this year small-cap stocks are so far outperforming large-cap equities by a margin of almost 3:1 in the month of December. The outperformance actually began in the middle of November, not surprisingly just about 30 days after small-caps started getting disproportionately hard-hit in mid-October, so arguments for a tax-loss selling basis may be valid. We have a different explanation.

According to Hedge Fund Research Inc., US Equity Hedge Funds returned approximately 20% on average through the end of October. Hardly a barn-burning snap back from last year’s almost universal decimation, but a return sufficient to place most funds squarely ahead of the major market index averages year-to-date as of month-end. Additionally, for some unknown reason, 20% seems to be a targeted return for many hedge funds. In any case, our humble opinion, having observed October’s rapid and brutal sell-off in small cap stocks (the equity asset class that led the market’s rise from the March lows), followed by a period of calm and a declining VIX, is that many hedge fund managers found themselves nicely in positive territory after last year’s drubbing and simply decided to take the rest of the year off and went to cash. Tax loss selling, while a conveniently-fitting explanation, really doesn’t apply this year as so many funds have loss carry-fowards from 2008 that may well last them the rest of the decade.

Our view might explain October’s dramatic underperformance but why, then, have small-caps once again reasserted themselves since mid-November? Well, while many hedge fund managers may think 20% is a good number and are able to sit in cash and play computer solitaire for the last two months of the year, many plain-vanilla funds are mandated to remain invested and perform relative the indices. Others just plain missed the rally and haven’t enjoyed the same level of returns. So for a large segment of the asset management industry, not only is the year not over but there is a fair amount of last minute catching-up to do. And we can’t think of a better way to gain ground on the averages than to pick up some high beta small-cap stocks that have been severely marked down for non-fundamental reasons. Also, with the broader averages now up more than the mid 20% range, a 20% YTD return no longer seems so special so we suspect that many hedge funds are now getting back in the game. So, although there is no empirical way to test our theory, if we are right then December may hold more good news for small company stocks in its remaining weeks.