At Hand Once Again: The Season to Consider the January Effect
With the market approaching the last quarter of the year, one of the most widely discussed anomalies of the stock market, the January effect, is once again fast approaching. While just how useful the January effect is for the individual investor will probably remain hotly debated in some quarters, my own work as well as other studies show that the January effect, if taken in the proper context, is a factor that investors can and should exploit.
First, the January effect is primarily a low price effect. While the market in general is influenced to some degree, the January effect is most evident in low-priced stocks, with low-priced stocks in January chalking up gains four times the overall market. Keep in mind that we’re not talking about small market capitalization (stock price times number of shares outstanding) stocks, but low-priced stocks—stocks priced at $20, $15, $10, $5 and under.
Second, the January effect is most prominent in markets that follow down markets. Since tax-loss selling and portfolio “house-cleaning” by both individual and professional investors are the most likely explanations of the January effect, it stands to reason that the number of stocks enjoying the January effect rise would be greater in markets following down years.
With the market in 1994 showing one of its most important declines in four years, and with the Dow down some 350 points and the S&P 500 down nearly 10%, the declines in individual stocks have been pretty hefty. There are some fairly well-known stocks down 50% or more and selling at very low prices.
Third, while the name implies a “January effect,” and many stocks do rise the sharpest in January, there is more to the January effect than just the month of January. Some stocks show their sharpest gains, for instance, in February, some in March, and so forth. Each stock has to be taken on a case-by-case basis.
More importantly, though, is the “start” of the January effect—that is, when stocks begin to rise. Stocks do not start to go up on January 1; rather, they begin to rise earlier. Accumulation usually starts prior to the official January effect “season.”
The sharp rises that investors see in January tend to “glamorize” the “mark-up” phase of a stock’s up market cycle, when stocks are rising sharply on high volume. However, the mark-up phase is just the acceleration point of the accumulation cycle. The prime time to buy is before the mark-up phase, when the earliest signs of accumulation are just beginning to build.
Buying during the earlier stages of accumulation is why technical analysis is so important in buying these stocks. Just because a stock is low-priced and depressed and the January effect season is approaching does not mean that a stock is going to rebound and advance, rather than continue to decline.
Buying low-priced and depressed stocks is risky. There are as many losses in low-priced stocks to be had as there are gains. The key is to buy stocks that are showing signs of bottoming out and accumulation. In a nutshell, technical analysis plays the key role.
Choosing an example of how to use technical analysis in selecting low-priced stocks that may benefit from the January effect is an easy matter. I simply look to see what stock performed best. While in any one quarter or year the names will change, the principles of accumulation via technical analysis are the same.
For this article, I’ve selected Rexene, the top winner on the New York Stock Exchange over the first six months of 1994. Not surprisingly, Rexene was a low-priced stock at the start of the year, priced at 27/8; it has captured the top spot so far with a rise of 129.0% over the following six months. Rexene was also depressed, with the company having just emerged from Chapter 11 bankruptcy proceedings in September 1992. True to form, the big winners usually come from low-priced and depressed stocks.
First, notice that the returns in Rexene that put the stock at the top of the list were primarily achieved in May. As I’ll explain, the stock did post its most important advance of the year in January; however, the spectacular run—the acceleration phase—that put Rexene at the top of the list did not kick in until May.
The point in time that a stock rises sharply is not just due to chance. Prior levels of trading, and in this case, resistance, dictate when the mark-up phase will develop. With Rexene, considerable stock was offered for sale by less than enthusiastic investors as the stock advanced in post-bankruptcy trading. Thus, the $4.25–$4.75 level provided formidable resistance. However, when the issue finally did absorb that resistance, the stock exploded.
A more important point is when the stock began to rise. Buying during the mark-up phase can be profitable, but not nearly as profitable as when the stock is beginning its gradual ascent. Gradual is an important description in terms of conceptualizing a stock moving from distribution to accumulation.
The swing from distribution to accumulation does not happen in a day. It does not even happen in a month, as the name “January effect” connotes. Instead, the process of moving from distribution to accumulation takes time and can be drawn out.
However, while such a swing period may try the patience of some investors, a long swing from distribution to accumulation is a plus for investors in that ample opportunities are provided to get in early at relatively lower-risk buying levels.
In viewing the swing from distribution to accumulation, consider the length of time when Rexene was either drifting lower or doing nothing. From January through late November of 1993, Rexene was either sagging, or had minor rallies that would lead to nowhere. The particular phase of distribution that characterized Rexene during the first 10 months of 1993 was “distress selling.” By November, the stock was selling at 2½.
Now, picking up a stock at the exact low is normally a matter of just plain luck. However, in November, Rexene had declined to important lows established in December 1992 at 2½. When low-priced and depressed stocks trade down to prior important lows after a long decline, it’s one reason to buy. When does an investor buy on declines? When a stock has declined to support!
After trading at 2½ for a few days, Rexene moved higher on a pick up on volume. In moving higher, Rexene not only found support at a logical support level, but the early December advance broke the downward momentum that had started in early September.
In the chart in Figure 1, zoom in on the November-December 1993 period—at that point, you can see a clear example of support and resistance in action. During September, October, and early December, 2¾ was support. When Rexene fell below that level in mid-November, 2¾ would become resistance (since the price was below the former support line).
I put a lot of importance in how a stock interacts with support and resistance levels. Not all stocks have identifiable support and resistance levels that can be used as landmarks, but low-priced and depressed stocks always do.
In mid-December when Rexene rose above 2¾, it was bullish. The downtrend was broken in the process, and at the same time, volume picked up as indicated by the vertical lines along the bottom of the chart.
The stock would rally to 31/8 and then decline. What is the logical spot for the retreating stock to find support? At 2¾. Once again, Rexene provided an opportunity to “buy at support.”
Describing how a stock interacts with support and resistance levels, in this case, 2¾, may seem a bit tedious. However, a stock’s interaction with its support and resistance levels is what provides us with a correct diagnosis of trends and what defines buying and selling opportunities. I do not know how to describe this process without the detail.
Subsequently, the stock would trade at 2¾ for a few days, and then move sharply higher to new highs on January 6 at 3¾. The move to 3¾ was Rexene’s most important move.
Now, readers who look at the January 1994 rally, and the sharp rallies earlier in the year, might ask themselves: “What is the distinction between the January 1994 rally and others?” The difference is that the January 1994 rally represented the first minor zigzag formation in Rexene in over a year.
Look back at the chart: There were plenty of sharp one- and two-day advances. However, there were not any zigzags, where the stock advances, hits resistance and declines, and then advances past resistance to higher ground.
The minor trend zigzag is usually the least important trend of the market. However, after a stock has been declining for months on end, the minor zigzag can be the most bullish formation investors can look for.
During the next few months, Rexene moved higher in the typical pattern of zigzags, just like walking up a flight of stairs. The stock advances sharply, then sags with volume declining, then again advances sharply with higher volume, and so on. Through the end of May, Rexene advanced within about as perfect a “self-correcting” trendline as can be expected.
Once through 5, the stock exploded—the stock had entered the acceleration phase. The advance above 5 was spectacular and, no doubt, was the time when many investors first noticed the stock. However, buying during the earlier phase of accumulation—in December, January, or February—not only leads to greater profits, but, in my opinion, is less risky.
Through June, Rexene was still operating within a fairly well-defined uptrend, with both advances and declines developing within a channel.
However, on the decline the last week of June, Rexene fell below support, which at that time was around 93/8, based on the early June highs of that level, as former highs form support levels. Once the stock failed to hold at the early June highs, it was a case of support failure.
That late June decline broke an upward trend. Trendlines do not form out of thin air; rather, they form as a function of support and resistance levels. When support at the 93/8 level failed, Rexene in effect broke its trendline. In any case, breaking below support at 93/8 and/or breaking the upward trend both indicated that the May-June advance had ended.
Has the major trend been reversed? There is no indication. Rexene may just trade between 8½ and 9 for a few weeks, and then start a renewed uptrend. On the other hand, if the stock instead proceeded to break below 8½, it would indicate that the entire move from the December lows of 2½ to the June highs of 11 was to be corrected. As it turned out, the uptrend was resumed and the stock moved to new highs in early August.
Rexene is just one of hundreds of low-priced and depressed stocks that follow similar patterns of accumulation and distribution. Each stock has its own personality, but the principles of trend development and how a stock interacts with its support and resistance levels are the same.
With the January effect season on us once again, investors should begin to look for clues of early patterns of accumulation.