Over at World Beta, Mebane Faber has a great post on the “January effect.”  That term describes the tendency of microcap and smallcap stocks to  dramatically outperform both on a relative and absolute basis during the month of January.  I’ve mentioned microcap seasonal tendencies several times, but Faber takes it a step further.  He has developed a simple strategy that takes advantage of the January effect:

One well documented effect is the historical outperformance for small cap stocks in January. A simple system of holding the smallest 20% of stocks every January since 1927 results in returns of around 10% a year (and that is without sitting in cash the remaining 11 months of the year which would add an additional 3.5% per annum to returns). That dwarfs the 1.5% return for the largest 10% of stocks in January.

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I usually have a hard time getting comfortable with strategies such as this as there needs to be a structural reason for the strategy working. Tax loss selling is a legitimate one as investors sell their losers at the end of the year to capture capital gains losses (and there should be plenty this year).

Another potential problem is data mining. Will the strategy hold up out-of-sample and has the strategy deteriorated over time? Buying the bottom 20% of stocks in January results in nearly 90% up years. 16 of the past 17 years have been positive with average returns of 9.6%. Even better, the strategy would have recorded up years during some of the worst years in the market. 1930: 18.66%. 1931: 23.32%. 2001: up 31.7%. 2002: up 4.8%. The worst January for the strategy would have been around -6%.

Faber suggests playing the strategy using microcap ETFs like IWC, which tracks the Russell Microcap Index. Large investors may also want to look at the DFA institutional mutual funds, which track the same market deciles that Fama and French used to test for microcap seasonality.

DISCLOSURE: No position in stocks mentioned, but long many microcaps.

Related posts:

1. Microcap Speculator now on Investimonials
2. 4th anniversary stock contest — $75 prize
3. Microcap seasonality could weigh on smaller stocks