Tuesday, December 18, 2007

January Effect

Ho, ho, ho, it's that time of the year... The city is shining with lights and colors, shoppers are flocking to the stores and investors are learning about the January effect. A strategy going long micro-cap stocks while simultaneously shorting an equivalent dollar amount based on the S&P500 future has been positive for 22 of the past 24 years: Mark Hulbert. Wikipedia.

One of the reason that explains this calendar effect is tax-loss selling. In December investors tend to dump their portfolio losers to take advantage of the tax cut. In January the selling pressure abates giving a boost to micro-cap stocks. Why micro-cap stocks in particular? Because lower liquid stocks have a higher chance to suffer from the December selling pressure than large-cap stocks. Also micro-caps tend to be more volatile and thus are the best candidates in December.

Today every folk on Wall St. and his mom knows about the January Effect and yet the strategy continues to deliver, including the last trade in 2006-2007. The reason is that it's actually hard to exploit this inefficiency with substantial capital due to the lack of leveraged instruments and liquidity in micro-cap stocks. But for the average investor there is still a chance to go long IWC (Micro-Cap ETF) and short SPY, or QQQQ.

I run the strategy on Hudson using SPY for the short leg and going long DFSCX, a micro-cap fund. All data is available for free from Yahoo for the last 11 years. After several runs I found the optimal period in terms of risk-adjusted returns from Dec-20 to Jan-9:
Records: 2797
Period: [1996-Jun-20/2007-Jul-31]
Total days: 4059
Hedge Records: 6961
Hedge Period: [1980-Jan-02/2007-Jul-31]
Hedge Total days: 10073

Trade results
Trades: 11
Avg trade: 2.37%
Std dev: 2.41%
Skew: -43.92
2SD Range: -2.45% | 7.18%
3SD Range: -4.86% | 9.59%
Pos trades: 9 (81.82%)
Neg trades: 2 (18.18%)
Avg pos: 3.21%
Avg neg: -1.42%
Best: 5.65% [1999-Dec-20/1999-Dec-20]
Worst: -2.29% [2004-Dec-20/2004-Dec-20]
Max cons pos: 6 [1996-Dec-20/2001-Dec-20]
Max cons neg: 1 [2002-Dec-20/2002-Dec-20]
Max drawdown: -2.29% [2004-Dec-20/2004-Dec-20]

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