The so-called January-Effect is almost at an end and if the mar­ket closes near these lev­els, the S&P 500 will have man­aged a 4.4% gain or its 20th best Jan­u­ary since 1928 (84 years) and best since 1997. The out­per­for­mance of banks and sov­er­eigns (LTRO) and the worst-of-the-worst qual­ity names (most-shorted Rus­sell 3000 stocks +9% YTD vs Rus­sell 3000 +5.2%), as Mor­gan Stan­ley noted recently, is not entirely sur­pris­ing since the Jan­u­ary effect is con­sid­er­ably larger in mid-cap and junk qual­ity names than any other size or qual­ity cohorts. We have pointed to the sea­sonal pos­i­tives in high-yield credit and volatil­ity and along with the obvi­ous short squeeze in S&P futures (which has seen net spec shorts come back to bal­ance recently), we, like MS, are con­cerned that the tail­winds of exu­ber­ance that vir­tu­ously reflect from seem­ingly piv­otal secu­ri­ties (such as short-dated BTPs now or Greek Cash-CDS basis pre­vi­ously) very quickly revert to a sense of real­ity (earn­ings and out­look changes) and per­haps the slow­ing rally and ris­ing volatil­ity of the last few days is the start of that turbulence.

The most-shorted stocks (tracked by the red lines on the above chart) have dra­mat­i­cally out­per­formed the broad mar­kets they are part of with the Rus­sell 3000 most-shorted (thick red) mas­sively out­per­form­ing (almost 400bps in the month!).

Mor­gan Stan­ley: Jan­u­ary Effect

Jan­u­ary is often a month for risk tak­ing since opti­mistic investors believe that any under­per­for­mance dur­ing the month can be reversed by year-end.

In light of the sharp rally in the equity mar­ket thus far this year, we took some time to study the con­cept of a “Jan­u­ary Effect.” Since 1901, the S&P 500 has aver­aged a 1.2% return dur­ing Jan­u­ary with a stan­dard vari­a­tion of 4.3%. In the remain­ing eleven months of the year, the index has aver­aged a 0.5% monthly return with a 5.2% stan­dard vari­a­tion (Exhibit 2).

After account­ing for the stan­dard devi­a­tions, the return spread between Jan­u­ary and the remain­ing eleven months is mar­gin­ally sta­tis­ti­cally sig­nif­i­cant: With a T-stat of 1.73, it is sig­nif­i­cant at the 10%-level but insignif­i­cant at the 5%-level. In fact, 2012’s rally to date is only a 0.8 stan­dard devi­a­tion event, and study­ing his­tory, we would expect such a move to occur in slightly over 20% of January’s. We stud­ied the “Jan­u­ary Effect” by mar­ket cap cohort, quality-junk sta­tus, and value-growth sta­tus. Since 1970, the spread between the Jan­u­ary return and the return for Feb­ru­ary through Decem­ber has been high­est in mid-cap stocks (Exhibit 3). None of the three cap cohort’s return spread is sta­tis­ti­cally significant—the mid-cap spread has the high­est T-stat at 1.46. Year-to-date per­for­mance so far this year by cap cohort is con­sis­tent with smaller-cap outperformance.

We ana­lyzed returns by qual­ity cohort since 1981 and found that both qual­ity and mod­er­ate qual­ity, on aver­age, per­form worse in Jan­u­ary than dur­ing the remain­der of the year. Low qual­ity slightly out­per­forms in Jan­u­ary, while junk is by far the largest out­per­former on aver­age (Exhibit 4). The more pos­i­tive per­for­mance of junk rel­a­tive to the other qual­ity quin­tiles is not sur­pris­ing given that junk stocks are gen­er­ally smaller than qual­ity stocks, and the Jan­u­ary effect is stronger in these small stocks. Still, none of the qual­ity cohorts’ return spreads are sta­tis­ti­cally sig­nif­i­cant after account­ing for volatil­ity and the num­ber of observations.

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