What does history tell us and how should investors react?

The January Effect

The January Effect is a pattern exhibited by stocks in the last few trading days of December and the first few weeks of January. During this period, particularly starting in January, the theory is that stocks tend to rise.

In simple terms, the January Effect is a consequence of:

  • Tax-loss selling, in which investors sell stocks that lost money at the end of December in order to take losses as tax deductions and
  • Mutual funds’ window-dressing, which is exactly as it sounds.

Because so many of these stocks that lost value were sold in late December, they will be – in theory – available at a discount in early January. Another purported cause of the January Effect is the payment of year-end employee bonuses, which employees invest in the stock market. As a result, investors with more money end up buying cheaper stocks, making the market more active and driving up prices.

Studies Confirm – The January Effect is not just a Wall Street myth as several prominent studies have confirmed its existence. One study of historical data from 1904 through 1974 discovered that the average return during January was five times larger than the average return for other months.

Another study showed that small cap stocks (as represented by companies in the Russell 2000) outperformed large cap stocks (as represented by companies in the Russell 1000) by 0.8% in January, but lagged large caps for the rest of the year.

From 2000 to 2018, however, the results were mixed: In nine of those 18 years, there were January gains, and in the other nine years, the market lost ground.

Effect Becomes Less Effective

In recent years, the January Effect has become less pronounced. As a result, it is a less effective way for investors to take advantage of the market. Once investors, economists and traders spot, analyze, and confirm the existence of a trend, it tends to become less pronounced.

Investors “price in” the trend, adjusting their investment strategies to take trends (like the January Effect) into account. Another reason that the January Effect is less important is that many people now use tax-sheltered retirement plans, like IRAs and 401(k) plans. When investments are tax-sheltered, there is no special reason to sell a stock for the purpose of deducting stock losses.

So, what about January 2019?

U.S. stocks turned in very positive numbers during the last trading week of 2018 on the heels of three consecutive weeks of declines. In a departure from previous years which usually saw little trading activity and smaller market movements, the final trading week was marked by high volatility and record days – a record Christmas Eve decline followed by a record point gain on the day after Christmas.

What does this start mean for January 2019? That’s anyone’s guess.

Using January to Predict 2019

Many investors and analysts have tried to use the January Effect for predictive value. However, there are different questions about predictions.

How well does the first week of January predict annual market performance? – Somewhat better. From 2000 to 2018, the first week of trading has predicted the stock market’s annual return about 67% of the time. From 1962 to 2018, however, a down market in the first week accurately predicts a bad year only 50% of the time.

How well does the entire month of January predict annual market performance? – About as well as a monkey making a coin toss. From 1962 to 2018, a below-par January accurately predicts a bad year only 55% of the time.

Remember January 2018? The markets were hitting new record highs and the S&P 500 ended January 2018 up 5.62%. And a lot has happened in 11 months since those January highs…

Conclusion?

As these numbers show, the January Effect is simply not a very good predictor of annual stock market performance. Of course, the S&P 500 has risen about 7.2% on average from 1950 through 2018. As a result, omens in January are unlikely to predict the entire year.