Preparing for the January Effect With ETFs

A new year has arrived and that means plenty of talk on Wall Street about the January Effect, the phenomenon where small-cap stocks power the market higher in the first month of the year, setting the broader market up for annual gains.

Investors were not enamored by small-cap exchange traded funds in 2015. Investors pulled $2.0 billion from the broad small-cap ETF, iShares Russell 2000 ETF (NYSEArca: IWM), which tracks the Russell 2000 index. IWM is the largest ETF tracking smaller stocks.

The S&P SmallCap 600 Index is currently trading at 18.6 times 2016 estimates, compared to the 18.1 times estimates for mid-caps and 16.5 times estimates for the S&P 500 index. Moreover, the small-cap index shows a price-to-earnings growth rate of 1.3 times, a discount to its larger peers of 1.6 times for mid-caps and 1.5 times for the S&P 500.

Potential investors should also be aware that the small-cap ETFs may have differing level of sector exposure than what many are used to. For instance, IJR has a greater financial exposure of 24% than the S&P 500’s 17%, along with industrials at 17% versus 10%. However, IJR shows a smaller 12% tilt to technology, compared to the S&P 500’s 17%.

The emergence of the January Effect could prove pivotal for the market’s fortunes in 2016.

“According to the Stock Trader’s Almanac, the direction of January’s trading predicts the course for the year 75 percent of the time,” reports Reuters.