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Goodbye 'January Effect' and Other Superstitions

The so-called "January effect" hasn't actually had much of an effect in recent years.

The term became part of the Wall Street lingo when analysts noticed that investors tend to sell small stocks at the end of a year to harvest tax losses then buy the stocks up again in January. The effect of this was to push up the performance of small caps relative to that of large caps in the first weeks of January.

New York Stock Exchange
Photo: Oliver Quillia for CNBC.co
New York Stock Exchange

The name is now a misnomer, as the trend actually begins much earlier. Investors try to get ahead of the game as early as the end of October, pushing up the performance of small caps well before the new year.

"There wasn't much of an advantage from 2002-06, although from 2007-09, small caps did well in the last two weeks of December, posting gains two to three times bigger than large caps," notes Jeff Hirsch, editor in chief of Stock Trader's Almanac.

For 2011, the effect seems to be holding up, but the window to play it is short. Hirsch said the effect began around mid-December.

"It should run to mid-January at least, but I do not expect it to be as wide a margin as some of the larger years," Hirsch said.

Last year, the Russell 2000, a barometer of U.S. small caps , beat the Russell 1000, a similar barometer for large caps, by just a smidgen during the last half of December. Small caps were up 2 percent, while large caps followed closely behind gaining 1.9 percent.

Investors know, or should know, better than to put too much stock in widely known superstitions, and the January effect hasn't been the only historical trend investors are betting less on.

The European sovereign debt crisis has kept a strong grip on the market even as the holiday nears and economists warn that political missteps in Washington would only add more uncertainty next year.

Investors got a fair load of surprises midweek — Oracle's disappointing earningshampered the Nasdaq Composite Index. And a decision from the European Central Bank to extend loans to eurozone banks proved that headlines surrounding the debt crisis aren't taking a breather. In short, macroeconomic headwinds can turn collective psychology on its head.

The highly anticipated Santa Claus rallyhasn't come in full force this year, although the year has a week left, and the last three days of rallying on the Dow are giving investors some hope.

"The economy is better shape than it was in 2009 and at the end of 2008, but we're not in the booming 90s right now. ... It's been a tough market this year," said David Rolfe, chief investment officer at Wedgewood Partners. "If we had rallied last week, I would have been more optimistic, but I don't think the sellers are done yet."

"I'm already tempering my outlook for 2012," said Hirsch, who explained that the loss of momentum in December reduces the likelihood of a strong January.

What happens come January brings us to the next stock superstition — the January barometer, which investor sum up by saying, "as goes January, so goes the year."

The hypothesis is that because elected officials move into their offices at the beginning of the year, investors can get an early sense of the year's political agenda. Thereby, January's stock performance became a rough predictor for whether it will be a down or up year.

"Since 1945 (excluding 2011), whenever the S&P 500 was up in January, it gained an average 11 percent in the remaining 11 months of the year, rising 85 percent of the time," says Sam Stovall, chief equity strategist with S&P Capital IQ.

According to Jeff Hirsch, whose father, Yale Hirsch, invented the barometer in 1972, the positive correlation between performance for January and the whole year has failed only seven times, including in 2009 and 2010. More importantly, "every down January since 1950 was followed by a new or continuing bear market, a 10 percent correction or a flat year."

The S&P 500, which gained 2.3 percent in January 2011, is down a fraction of a percentage point as of Thursday's close. The barometer hasn't held up as well during recent crisis years, says Hirsch, adding that lower bonus expectations on Wall Street is translating into less juice for the current trading climate.

Economists say the economy faces several headwinds in 2012, and that a recession remains on the table despite signs of improvement in both the job and housing markets. Finance ministers and political officials in Europe have again and again come up with plan to fix the debt crisis. But as investors grow cynical that any one plan can be an ultimate backstop for the crisis, eurozone borrowing costs have continued to soar and stocks have continued to react negatively.

Further slowdown in the economies of Europe or Asia could disrupt the domestic recovery. But if the U.S. economy begins to show cracks, then the Federal Reserve may introduce new stimulus measures. S&P Capital IQ puts the odds of a double-dip recession in the U.S. at 35 percent for the summer of 2012.

Because all these events are difficult to predict, whether the January barometer will hold up next year is a big question mark.

David Rolfe says most investors view such trends as just good fun. They don't factor into investment decisions. "There's no timing mechanism as part of our investment philosophy," says Rolfe, whose 2011 portfolio included high-quality defensive stocks, such as Apple and Berkshire Hathaway.

A few superstitions are no longer even talked about in the investment community. October used to show some of the strongest gains of the year because it was the time of the harvest. But with less than 2 percent of the nation's economy derived from farming, investors have stopped counting on that trend.

Rolfe, however, says he gives some credence to the third-year phenomenon, which predicts that stocks do better during the third year of a presidential term than during the first two years of a term. The supposed reasoning is that the administration introduces more stimulus measures in preparation for re-election in the four year. "Sometimes it's like holy cow, there's something here," says Rolfe.

The Dow is up 5.1 percent so far in what is President Obama's third year. The index was up 21.3 percent in 2009 and 9.4 percent in 2010.

But there's one superstition that has been spot-on for 2011: The popular saying "sell in May and go away" couldn't have been more enlightening in retrospect. A lot of investors probably wished they had followed that one.

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