The January Effect and Market Seasonality

To most investors, stock market seasonality is just one more theory, often ignored unless it’s part of your market timing system. But seasonality always gets a second look as the calendar rolls over at the beginning of a new year.

The spike in interest is partly psychological; beginning a new year makes investors more aware of and interested in calendar-based effects. And long-term forecasting has a moment in the spotlight at the beginning of a new year, as analysts try to make full-year predictions, which some seasonal theories can address.

But the sudden attention to calendar-based effects isn’t just a product of investors’ mindset: seasonality really is stronger at the beginning of the year. Seasonal effects related to January tend to be more consistent than those related to other times of year. So it’s actually the most profitable time of year to pay attention to seasonality.

One of the most consistent seasonal patterns is simply called the “January Effect.” In short, the market tends to do well in January. Small stocks and the prior year’s underperformers tend to do particularly well.

There are a number of reasons given for the January Effect; the most frequently cited is that it’s a rebound from tax-loss selling that depresses the market in December. The sellers, the explanation goes, then buy back losing stocks they sold for the tax offsets in December. New investors may also be tempted by the low valuations.

Another partial explanation says that institutional money managers sell their losers and risky bets in December so they can show clients a more reassuring portfolio at year-end. Then, the explanation goes, these “window dressers” buy back the stocks—or replace them with different small or risky stocks—in January, contributing to the January Effect.

Both explanations are pretty well accepted. But there may be a psychological component to the January Effect as well. In short, beginning-of-the-year optimism may be behind some of the month’s consistent gains. This explanation says that the same old-fashioned New Year’s optimism that makes people join gyms and eat healthier at the beginning of the year also creeps into their investing decisions.

“Investors, exhibiting the same flash of wishful thinking exuded by any New Year’s resolution maker, take a flier on those little stocks that ‘have great potential,’” wrote Stephen Ciccone, an associate professor of finance at the University of New Hampshire’s Whittemore School of Business and Economics, in an opinion piece in the January 18 New York Times. “Why doesn’t the January Effect disappear in anticipation of the January Effect,” Ciccone continues, “as investors try to take advantage of what’s coming? … The theory is that people are optimistic at the turn of the year and often make idealistic resolutions: lose 50 pounds, write that novel, cut down the binge spending or make a windfall in the stock market. As the year progresses, they fall short of their goals and eventually forget or give up. But come next January, the goals are back, starting the cycle of failure and renewed effort all over again.”

Obviously Ciccone can’t give any hard evidence for it (he tries with some information from brain scans, but it’s not a direct link), but I like this explanation anyway, at least to account for part of the January Effect, because investor psychology is truly a powerful thing.

The other seasonal effect that receives popular attention at this time of year is the January Barometer.

The January Barometer says that if the market ends January with a gain, it will also end the year up. And if the market is down in January—rare, but it happens—it will be a losing year, overall, for the market.

The analysts at Stock Trader’s Almanac are the experts on, and staunchest defenders of, the predictive power of this indicator. Last week, Jeffrey Hirsch, editor-in-chief of the Almanac, sent subscribers an investor alert titled “Not Perfect, But Undeniable January Barometer Track Record Warrants Respect.” In it, he strove to head off the inevitable February “attempt at disparaging this faithful indicator.”

One persistent criticism of the January Barometer is that, although it works, since January is so frequently positive, it’s not much more effective than simply assuming every year will end with a stock market gain. Hirsch responded to these critics:

“Statistically, they are just about right. In the 75-year history examined in this article, there were only 22 full-year declines. So yes, the S&P 500 has posted annual gains 70.7% of the time since 1938. What is missing from this argument is the fact that when January was positive, the full year was also positive 89.4% of the time and when January was down the year was down 60.7% of the time. We also know from above, that every down January on the S&P 500 since 1938, without exception, has preceded a new or extended bear market, a 10% correction, or a flat year.

“By entirely ignoring the January Barometer, a trader or investor is simply accepting they will lose money 29.3% of the time based upon the historical performance of the S&P 500. … Although the January Barometer is not 100% accurate, it does provide an advantage over simply guessing ‘higher’ every year, increasing your odds at making money and perhaps even more important, not losing money.”

So far this year, the January Effect has arisen once again, and the major indexes are all up around 4%. With just a little over a week left in January, the January Barometer is likely to predict good things for the rest of the year. Of course, expecting an overall gain for a yearlong period isn’t really enough information to base an investing strategy on. Investors using market timing will likely get in an out of the market several times over the next 12 months, to take advantage of shorter rallies and bearish phases. But I think it’s nice to have an optimistic background to that trading.

What do you think? Is the January Barometer useful as a general predictive tool, or is it too blunt or too obvious to be practical? And can the January Effect be explained entirely by tax-loss selling and window-dressing, or does investor psychology play a role? Let me know by replying to this email.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week

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