The January effect after the Santa rally

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It took a while, but the Santa rally finally showed up, courtesy of Janet Yellen and her busy elves at the Federal Reserve’s Washington grotto. The 10-year Treasury yield was last night up 15bp from Wednesday morning, the biggest two-day rise this year, while the S&P 500 is up almost 4 per cent, the biggest two-day gain since 2011.

The next thing for investors to look forward to is the January effect, the tendency of risky assets to do better at the start of the year. Over a long period, equities have performed better in January than in the rest of the year and smaller companies and emerging markets even better. Other risky investments such as junk bonds, the search for yield known as “carry”, hedge funds and the most volatile shares outperformed in January, too.

It seems investors came back from their holidays refreshed and ready to take risks again — something institutionalised in many banks and hedge funds by the annual resetting of bonuses and risk limits.

The effect has faded in recent decades. Januaries since the crisis have on average been poor for equity investors (see chart) and even worse for those who concentrate on smaller companies.

But it turns out the premium for smaller companies in January has never gone away. It was just measured wrong. Rather than small companies as a whole outperforming, the January effect sees the junkiest, lowest-quality small companies do well. At the same time, in January high quality smaller shares underperform, according to research by Tobias Moskowitz, the Fama family professor of finance at Chicago Booth, as part of a forthcoming paper with colleagues at AQR Capital.

Long-term investors should not rush out and buy small companies with unreliable earnings or low profitability, two of the measures Mr Moskowitz used. These low-quality shares may do well in January, but tend to underperform the rest of the year, offering another example of the error most finance theory makes in assuming that riskier investments offer higher rewards.

But for those who want to follow up the Santa rally with another quick punt, more often than not the place to be at the start of January is in second-rate smaller companies.

james.mackintosh@ft.com

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