It’s finally January and now could be the time for traders to take positions intended to benefit from the January Effect.
Investment managers and the academic community have long recognized that stocks do well in the first month of the new year. They called this tendency “the January Effect” and defined it as “a seasonal increase in stock prices during the month of January. Analysts generally attribute this rally to an increase in buying, which follows the drop in price that typically happens in December when investors, engaging in tax-loss harvesting to offset realized capital gains, prompt a sell-off.”
Understanding the cause of the January Effect points to a potential trading strategy. Some analysts believe the cause is related to tax planning. They argue investors focus on their taxes late in the year, an argument that seems sound. Many investors will realize they have a number of gains late in the year and they know one of the few tactics available to reduce the tax bill is to sell stocks that show losses. This strategy creates capital losses that offset capital gains and is fully legal as a tax minimizing strategy.
Other analysts have found that tax planning can not be the only factor that causes the Effect. Researchers have studied the tendency of stocks to rise in a variety of countries. They found a January Effect in Japan and Canada when those countries had no capital gains tax and therefore no reason to take losses in December. A January Effect also exists in Great Britain, according to researchers, even though that country’s tax year begins on April 1. Australia’s tax year begin on July 1 yet researchers also find a January Effect in that country. These studies indicate there is something unusually bullish about January.
Additional research has demonstrated that the January Effect is most pronounced in small stocks. Combined, all of these studies point to a potential trading strategy.
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First, we want to focus on small cap stocks. Then we will limit our potential buys to cheap stocks and we will limit potential buys to stocks trading at less than $5. Low-priced stocks tend to deliver gains when the more speculative sectors are doing well.
We are also limiting potential buys to stocks which show a forward price-to-earnings (P/E) estimate greater than zero. This accomplishes two objectives. By requiring a forward P/E ratio we are only reviewing stocks that have published earnings estimates for the coming year. This means we are finding stocks that are followed by analysts and it is possible they could be the subject of research reports that attract institutional buying. A positive P/E ratio limits our buy candidates to companies expected to be profitable in the next year, reducing the speculative component of the trading strategy,
Finally, we will look for stocks experiencing short-term pullbacks in long-term up trends.
This strategy should allow us to benefit from the psychology that appears to be partly driving the January Effect. By looking for long-term up trends, we are finding high relative strength stocks, the kind that academic studies show have a strong tendency to outperform the stock market. By buying pullbacks, we are looking for stocks that could be attractive to individual investors who are disappointed they missed out on the gains of the stock. They often view pullbacks as an opportunity to buy on a dip.
These are stringent requirements and just six stocks made the cut.
Lantheus Holdings, Inc. (NASDAQ: LNTH) develops, distributes and commercializes innovative diagnostic image agents and products. LNTH assists physicians in the diagnosis of conditions affecting the heart, brain, lungs and other organs using echocardiography and nuclear imaging technologies. Analysts expect LNTH to report earnings per share of $0.77 in 2017. They expect earnings to grow an average of 14% a year. Using the expected growth as the price-to-earnings (P/E) ratio, a valuations technique known as the PEG ratio, provides a price target of $10.70 for the stock.
China Automotive Systems, Inc. (NASDAQ: CAAS) is a leading supplier of power steering systems and components to China automotive industry. CAAS has business relationships with more than sixty vehicle manufacturers including General Motors (GM), Volkswagen, Citroen and Chrysler North America. With expected EPS of $0.83 and an expected earnings growth rate of 10% a year, the PEG ratio provides a price target of $8.30 a share.
ARC Group Worldwide, Inc. (NASDAQ: ARCW) is a leading global advanced manufacturing and 3D printing service provider. ARCW offers advanced manufacturing technologies and cutting-edge capabilities to improve the efficiency of traditional manufacturing processes and accelerate their time to market. ARCW also has significant expertise in 3D printing and imaging, advanced tooling, automation, machining, plastic injection molding, lean manufacturing, and robotics. ARCW is a small company with a niche in a growing industry and could be attractive to a larger company in the industry or a competitor looking at accessing the industry. ARCW trades at a 20% discount to the industry based on the price-to-sales (P/S) ratio.
Gerdau S.A. (NYSE: GGB) is a leading producer of long steel in the Americas, and one of the largest suppliers of special long steel in the world. GGB is also one of the largest suppliers to the automotive industry worldwide. The offers semi-finished products, such as billets, blooms, and slabs; common long rolled products, including rebars, merchant bars, and profiles that are used by the construction and manufacturing industries; and drawn products consisting of barbed and barbless fence wire, galvanized wire, fences, concrete reinforcing wire mesh, nails, and clamps, as well as iron ore. Steel producers could benefit from the trade policies of the new administration. The company is expected to report EPS of $0.58 in 2017. At just ten times earnings, the stock could be worth $5.80.
SORL Auto Parts, Inc. (NASDAQ: SORL) develops, manufactures, and distributes automotive brake systems and other key safety related auto parts to automotive original equipment manufacturers, or OEMs, and the related aftermarket both in China and internationally. The company’s products are principally used in different types of commercial vehicles, such as trucks and buses. Analysts expect the company to report EPS of $0.76 in 2017. The stock has historically traded at 6 times earnings, providing a price target of $4.56.
Quantum Corporation (NYSE: QTM) specializes in scale-out storage, archive and data protection, as well as providing intelligent solutions for capturing, sharing and preserving digital assets over the entire data lifecycle. QTM offers StorNext 5 software and hardware that offer file sharing and archiving in purpose-built configurations of metadata controllers, expansion appliances, and disk and archive enabled libraries; Xcellis product, which optimizes workflow and shared access by combining functions into a compact, space, and energy-saving solution; and Lattus Object Storage solutions that enable high volumes of data to be available to extract valuable information. QTM is a small, profitable company that could be attractive as a buyout candidate. The stock is priced at just one-third the industry average P/E ratio, offering a potential acquirer a relative bargain.
These stocks could all be good investments at any time of the year but they are especially promising, at the time of year when small cap stocks have a tendency to outperform.