By: Larry MacDonald

We’ve had the kind of year where small caps could see a nice rebound in January. This so-called January Effect, goes one theory, is tied to tax-loss selling at the end of the foregoing year. The selling dampens prices for underperforming stocks at year’s end and results in a January bounce as many of the tax-loss investors re-enter their positions. The pattern tends to be more pronounced in small caps because they are less liquid.

On average, says the Stock Trader’s Almanac for 2009, buying stocks trading at 52-week lows in the week before Christmas and holding them for a 4- to 6-week period has generated average gains of 13% since 1974, versus 3.4% in the market. This “Free Lunch” strategy performs best, says the Almanac, after market corrections and when there are a lot of new lows. That would seem to fit the description for 2008.

In the interests of disclosure, I should mention that I purchased a small-cap exchange-traded fund in November (iShares CDN Small Cap Index Fund). It’s intended as a long-term investment, but a nice uptick in January would help improve the morale.

By the way, for anyone still contemplating tax-loss selling, there is some academic research that suggests it may be better to do it in January, believe it or not. Apparently, you would be further ahead because the price gain from the January effect would on average offset the lower tax-loss claim.