The “January Effect“ is a well-known market phenomenon famous for causing the stock market to rally during the month in most years.

It’s considered an anomaly because it’s not driven by the market’s forces. A widely agreed-upon explanation around this event is that investors sell stocks at the end of the year for tax reasons and reinvest again at the beginning of the year. Another famous explanation is that investors use the money they earned in bonuses to invest, typically at the first of the year.

Since 1950, the market has posted more gains in January than it has posted losses, so investors have come to expect a positive performance at the start of the year. 

Take a look at the chart below….

Many investors are expecting an even bigger upside this year as uncertainty over the “fiscal cliff” subsides and economic data begin to improve in other parts of the world. Headlines of private meetings between President Barack Obama and Republican Speaker of the House John Boehner have already pushed stocks up 6% in the past month and as investors expect even higher prices into the New Year. 

But these investors could be in for a shock come January 2013.

Two very powerful and unavoidable forces could send the market down in January, so investors should prepare their portfolio. 

Here’s why…

The January effect, reversed
Driven by tax-loss selling and accentuated by low volume around the holidays, the January Effect is most notable in the performance of small-cap stocks and those with weak performances in the prior year. The anomaly is caused by investors dumping losing stocks in December to offset gains in others and lower their tax bill. 

This leads to selling pressure and underperformance particularly in the small- and mid-cap market through mid-December and an outperformance in January. January returns of the S&P 1500 have outperformed the larger companies in the S&P500 by an average of 5.9% during the past four years and the demand for stocks after the December selling generally brings the overall market up as well.

This dynamic may have changed with the prospect for higher tax rates next year. With higher taxes coming next year for at least some income groups, investors will want to pay as much of their capital gains at current rates and hold off on selling their losers until next year. This could lead to less-than-expected selling pressure this December and less rebound demand in January. 

If that were the only issue facing January’s market, then I might be a little more optimistic.

A fiscal cliff deal, but now what
The resolution of the fiscal cliff and all the accompanying bickering in Washington are a daily discussion among me and my colleagues. Without a resolution, the market could face increasing downward pressure the closer we get to the end of the year. Many are still expecting a last-minute resolution but seem to have forgotten the debacle around the debt ceiling just last year. Even if Washington comes to an agreement, then the damage to consumer and business confidence may already be made. This negative influence will likely show through in January.#-ad_banner-#

Even a compromise will still take away about 1.5% of annualized gross domestic product during the first quarter as a result of some fiscal policy expirations. Along with other likely spending cuts and tax increases in a resolution, there is no denying the fact that the economy will face a fiscal headwind in the first half of next year.

How to protect your portfolio
With headwinds of growth and technical hurdles related to the new tax rates, the risk of a market drop in January is greater than the risk of missing out on a market rally to the upside. If the market is poised for a January reversal, then investors will likely want to avoid cyclical stocks with higher multiples such as Virgin Media (Nasdaq: VMED) and AOL (NYSE: AOL). Virgin Media trades at 27 times trailing earnings and has seen its revenue drop 1.3% on a five-year basis. The once great Internet giant AOL is priced at 32 times trailing earnings and has seen its revenue slip by an average 15% each of the past five years.

Large company bellwethers with strong fundamentals should hold up well through any market turbulence. Stocks to position for protection are the old favorites such as Coca Cola (NYSE: KO) with its strong brand loyalty and 2.7% dividend yield. Compared to its peer group, pharmacy and retailer CVS Caremark (NYSE: CVS) trades for a relatively low 16 times trailing earnings and pays a 1.8% dividend. The pharmacy side of the business is strongly supported by the flu season in the short-term and by a growing aging demographic in the long-term.

Investors who don’t want to sell their positions, but want to protect themselves against market disappointment might look at a basket of stocks such as the exchange-traded fund (ETF) ProShares Short S&P500 Fund (NYSE: SH) which moves up when the general index drops. I like this ETF because it gives investors a chance to take an insurance position on the market against their stronger individual stocks without having to get into options or short-selling.

Risks to Consider: Any time an investor tries to time the market with a horizon of less than a month, the risk is that the thesis will not play out. Investors should use the information as a warning to not get overly exuberant about a possible January run and not dramatically change their investment strategy in hopes to profit from the January effect next year.

Action to Take –> Blindly taking a position ahead of the January Effect this year could lead to unexpected losses as new tax laws reverse the normal scenario. Investor sentiment could also turn negative because of fiscal hurdles ahead, which would also lead to a weaker market performance. Investors should position their holdings more conservatively and protect their gains while waiting for a better market toward the end of the first quarter next year.

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