'January Effect': Early bird gets small-stock profit worm

Message to potential stock speculators: It might already be too late to profit big from the so-called January Effect, a seasonal phenomenon in which small stocks post bigger returns than big stocks in January.

The reason: In the past 20 years, the biggest gains from the January Effect have occurred not in January, but in the last half of December.

Statistics compiled by the Stock Trader's Almanac confirm this emerging seasonal performance quirk. Going back to 1987, stocks in the small-company Russell 2000 index have posted average gains of 3.2% from Dec. 15 through Dec. 31. In contrast, the large-company Russell 1000 posted gains of just 1.7%. That pattern remained in force in the final two weeks of '07, when the small-company index rose 1.6%, compared with a 0.1% loss for the large-cap index.

The performance gap narrows sharply in the month of January, with the Russell 2000 gaining 1.6% on average, less than half a percentage point better than large-cap stocks. And with the stock market staring into headwinds, including $100 oil and fears that the economy will slip into recession due to the housing bust, the outlook for stocks in the first month of 2008 is not particularly bullish.

Indeed, in the first two trading days of '08 the Russell 2000 is down 2.7%, while the bigger-cap Russell 1000 is down 1.5%.

Historically, smaller illiquid stocks have tended to fare very well in the first month of the year because the prices of these shares are typically beaten down sharply due to year-end tax-related selling. This creates value and leads to an increase in the prices of these battered stocks in January as selling for tax purposes dries up and new buyers emerge, notes Paul Hickey of Bespoke Investment Group.

"It generally pays to get a head start on the January Effect in mid-December," advises Jeffrey Hirsch, editor of the Stock Trader's Almanac.

Like most stocks, small fry benefit from the fresh cash that enters the stock market early in the year, thanks to year-end bonuses and dividend payouts.

As is often the case on Wall Street, when specific winning strategies become so well-known, savvy investors find new ways to exploit them. In this case, they load up on small-cap stocks early, in some instances as far back as October.

In general, January tends to be the best overall month for small-stock performance, and just the third-best month for large-company stocks, as measured by the Standard & Poor's 500 index.

January is also a very good predictor of full-year stock performance. "Down Januarys are harbingers of trouble ahead," Hirsch warns.

But that hasn't stopped strategists like Hickey from coming up with lists of beaten-down small stocks that might be poised for a traditional January Effect rally. In a post-Christmas research report, Hickey rattled off 33 names he says have potential: Well-known names on the list include trendy footwear maker Skechers USA skx, specialty retailer Jo-Ann Stores jas, restaurant chain P.F. Chang's China Bistro pfcb, and even Martha Stewart Living Omnimedia mso, the media and merchandise company founded by domestic doyenne Martha Stewart.