Prepared by

The Kansas City Board Of Trade

Few seasonal trends are as widely discussed as the January Effect (this is the eighth year Market Watch has reviewed the phenomenon), but despite common knowledge of the anomaly, it continues to reappear with remarkable regularity.

This year several new factors could influence both the magnitude of the January Effect and the methods used to profit from capturing it. This newsletter examines the outlook for the effect and discusses trading strategies to capture it using stock index futures, such as the Kansas City Board of Trade's Mini Value Line.

Market observers traditionally have defined the January Effect as the tendency for stock returns to be larger in January than in any other month of the year, especially for the stocks of small companies. January Effect research doesn't suggest the markets will rise each January. What it does suggest is that particularly in January, small stocks tend to outperform large stocks, whether the general market tenor is up or down.

Typically, once outperformance of this nature becomes more widely known, the market becomes efficient and the anomaly disappears. But, according to Donald Keim, professor of finance at the Wharton School of Finance at the University of Pennsylvania, the January Effect has not gone away and, “though it may be slightly smaller, it is still very significant statistically.”

In an April 14 paper “Is there still a January Effect?,” Keim along with David Booth of Dimensional Fund Advisors, Santa Monica, Calif., concludes that, “the January Effect is alive and well, but difficult to capture. Short-term round-trip transactions in common stocks intended to capture the January size premium are unlikely to be profitable because of transaction costs.”

This may explain why one popular way to capture the effect is to own a basket of stocks through stock index futures, rather than trading individual equities. By owning futures based on a broad market measure, such as the Value Line Arithmetic Index, and selling futures pegged to a blue-chip measure, such as the S&P 500, an investor can attempt to capture the outperformance of small stocks that frequently occurs at the turn of the year. This year, additional spread trading opportunities are available as a result of the introduction of smaller-sized contracts to trade against the KCBT Mini Value Line.

In their paper, Keim and Booth recap early academic studies (beginning in 1976) of the effect. They compare returns since 1981, when the effect became more widely known, to returns from 1926 to 1981, which were analyzed in the earlier studies. The study on the earlier period found that 50% of the annual outperformance of small stocks was concentrated in January, and after correcting for an upward bias in average returns for small stocks, the size effect was evident only in January.

In both studies, New York Stock Exchange issues were ranked by capitalization, and the top 10% and bottom 10% were compared. From 1926 to 1981, the small-cap portfolio outperformed the large-cap portfolio by 10.80 percentage points in January. From 1982 to 1995, the small-cap portfolio outperformed the large-cap portfolio by 4.48 percentage points, despite a prolonged period of large-cap outperformance from 1983 to 1990. In addition, the performance of the small-cap portfolio from 1982 to 1995 was not significantly different from the period of 1946 to 1981.

Time Period	All Months	January		Feb.- Dec.

1926-1981	0.81		10.80		—0.10

1982-1995	—0.33		 4.48		—0.76

One influence on this year's January Effect outlook is the capital gains tax cut passed by Congress. Claudia Mott, director of small-cap research for Prudential Securities, says the change may provide an added boost for the January Effect this year. Mott argues that investors will take advantage of the lower tax rate this year to sell stocks that have appreciated in recent years during the long bull market.

“I think there will be a January Effect this year, if for no other reason than so many people believe the effect won't occur,” Mott says. “One reason is the tax law changes. I think a lot of investors will cash in long-term winners to take advantage of the new lower rate. This will drive down prices at the end of the year, setting up the turn-of-the-year bounce.”

Selling to capture gains at the end of the year is the opposite of one reason given for the effect in the past. In previous years, theories about the January Effect's causes have included ideas that investors sold off laggard stocks from their portfolios in December to of set capital gains they made during the year. Then, in January, investors looking for bargains scooped up these same stocks, driving prices back up. But this year, the new tax law cuts the long-term capital gains rate by nearly a third to 20%, down from 28%. The rate is even less for taxpayers in the 15% bracket. For a gain to qualify as long-term, assets must be held for 18 months versus 12 months under the old law.

Under this scenario, according to Money magazine, investors do not have as much incentive to sell losers at the end of the year. In fact, the magazine suggests the best tax strategy is to sell losers only in years when there are short-term capital gains and other income to offset. Here's why: If an investor in the 28% income tax bracket offsets $3,000 in short-term gains with $3,000 in capital losses, he saves $840 in taxes ($3,000 times 28%). If the investor uses the losses to offset long-term gains, he saves just $600 ($3,000 times 20%).

But Keim says, “My guess is that this change (in the tax laws) will be minimal where tax-loss selling is concerned. Who knows where the bulk of the selling has come from. For institutions, for example, the change in the tax laws is largely irrelevant.”

Theories on why the January Effect occurs vary widely. Keim suggests that one reason for the effect is the wide-bid/ask spread of many smaller, illiquid stocks. He says it isn't uncommon for these stocks to have a bid/ask spread that varies as much as 5%. Keim explains that near the end of the year as these stocks come under selling pressure, the stocks trade nearer the bid. Then, as this pressure subsides after the new year, trades occur near more normal levels.

There are several other theories about the January Effect, which according to some research has occurred about 90% of the time since 1926. Including the tax-loss selling mentioned earlier, other ideas are that:

–Small stocks are neglected during much of the year, but when investors revisit their portfolios at the beginning of the year they often add some to the mix.

–Smaller stocks come under end-of-the-year pressure by “window dressing,” or a tendency by portfolio managers to clean the stocks of smaller, lesser-known companies out of portfolios for reporting purposes. The stocks are then repurchased after the reporting period ends.

Previous issues of Market Watch have looked at the use of a Value Line/S&P 500 futures spread or a Value Line/New York Composite Index futures spread to capture the January Effect. These trades are still viable, but this year there are additional spread trading possibilities following the launch of two new contracts. The E-mini S&P 500 contract at the Chicago Mercantile Exchange and the Dow Jones Industrial Average Index SM (DJIA) futures at the Chicago Board of Trade present investors with two new spread options to consider to capture the opportunities presented by the January Effect.

Mott says because the January Effect tends to favor small-cap stocks, the E-mini and Dow contracts, which are based on blue-chip-dominated indexes, do not work well when traded outright to capture the effect. However, they can be used to capture the effect if they are sold as part of a spread, such as against the Mini Value Line.

The Mini Value Line, which is based on the Value Line Arithmetic Index, is considered by many analysts to be an excellent vehicle for trading the effect, and has the added benefit of being a smaller size more affordable for individual investors. Because of the Value Line's equal weighting, it is considered a good measure of the small-cap stock market.

By buying the Mini Value Line as the small-cap leg of a spread and selling the E-mini as the blue-chip leg, an investor can try to benefit from the outperformance of smaller stocks. If small-capitalization stocks rise faster or fall slower than blue-chip issues, the position will gain in value.

Because of the short history of the E-mini, it's impossible to look at how the spread between the futures contract behaved in the past. However, Moore Research Center in Eugene, Ore., analyzed the cash indexes the two contracts are based upon and pinpointed trading dates that have been the most advantageous in past years. Moore found that the Value Line Arithmetic Index gained on the S&P 500 when traded on a one-to-two basis in all 15 years of its analysis. The average profit was $526 or $557, depending on which date the trade was entered.

The stocks were analyzed on a basis of one Mini Value Line to two E-mini S&P 500 contracts to most closely represent an equal dollar amount. The Mini Value Line trades at $100 times its underlying index, while the E-mini trades at $50 times its underlying index. Recently, the two indexes have traded within approximately 60 points of each other.

This will be the first year it is possible to trade Value Line futures versus DJIA futures. By purchasing the Mini Value Line and selling the Dow, similar to the Mini Value Line/E-mini spread, an investor can attempt to benefit from the outperformance of small-cap stocks versus blue-chip stocks. In its analysis, Moore Research Center found two trades that would have been successful in 14 out of 15 years. The average profit was $338 or $462, depending on when the trade was entered. Again, this analysis was done using the cash indexes since the DJIA futures contract did not exist. These trades were analyzed on a one-to-one basis because the dollar amount of each contract is roughly equal. The DJIA trades at $10 times the underlying index versus $100 times for the Mini Value Line, but the DJIA index trades at roughly 10 times the value of the Value Line Arithmetic Index.

The Mini Value Line has traded at the Kansas City Board of Trade since 1983. It was created to provide an alternative for individual investors and smaller firms uncomfortable with the financial commitment of the bigger indexes. It has experienced steady growth through the years, and is on track to trade record volume this year.

Several cautionary notes apply in regard to the January Effect. First, the performance of the small-cap/large-cap spread will change as the time frame studied is adjusted. Also, as more people try to participate in the phenomenon, markets could become efficient and reduce or eliminate the opportunity for profit. As with any investment, investors should investigate the risk and appropriateness of trading futures before entering into a transaction.

November 4, 1997Kansas City Board of Trade

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