Investment choices are made primarily on the basis of probability. We set goals such as capital preservation, capital appreciation, or yield – and then we make judgments about which investments most probably get us to those goals.
The sense of probability we seek can come from a bunch of different places, like historical performance of a stock or an industry; recommendations from friends or trusted financial professionals; personal knowledge of an industry or particular company; “technical” studies such as trading charts; events that drive industries; macro-economic events; or historical patterns, among others.
It is the historical pattern called “the January Effect” that interests us on the Feast of Stephen (Boxing Day if you prefer) this year. Will it help us next month after a fairly rocky December and a bruising autumn? (If you are the type who wants to know whodunit at the beginning, the consensus answer is “yes.”)
Wikipedia says the January Effect is the “tendency of the stock market to rise between December 31 and the end of the first week of January.” Other people define it as lasting the whole month of January. Wikipedia goes further to say that the “January Effect has been observed numerous times throughout history.” A tad overstated, but it probably agrees with popular theory. http://en.wikipedia.org/wiki/January_effect
Yesterday (Christmas Day), author and market strategist Michael Carr had a careful look at the January Effect in Seeking Alpha http://seekingalpha.com/article/112267-the-january-effect-explained . He attributes the belief in the January Effect to the same cause as Wikipedia, namely that “investors choose to sell losing positions at the end of the year” for tax purposes, and then the cash flows back into stocks in the new year. He also notes that the January Effect has been noted in the market since 1802. His statistical analysis seems to verify that stocks like to move higher in January, most pronouncedly the Nasadaq Composite. The Russell 2000 actually underperforms in the first week of January, he says, but outperforms the rest of the year somewhat for the full month of January. In fact, all the indices he looks at have a better January than the average of the rest of the year.
For a second opinion, Mark Haug and Mark Hirschey presented a hefty study of the January Effect in the Financial Analysts Journal a couple of years ago (September/October 2006), and conclude that January shows “abnormally high rates of return on small-capitalization stocks. . .” They add that the effect in small-cap stock returns “is remarkably consistent over time.” http://www.cfapubs.org/doi/abs/10.2469/faj.v62.n5.4284
Oops! A downer. Dan Caplinger authored a piece on Motley Fool on December 3 called “The January Effect Won’t Save You.” http://www.fool.com/investing/general/2008/12/03/the-january-effect-wont-save-you.aspx Mr Caplinger did his tax selling earlier in the year, he tells us, and fears that the January rally may not materialize due to the large losses that many investors – funds and individuals – incurred this fall. He looks specifically at some equity basket cases, and speculates that potential changes in capital gains taxes under a new administration might convince people to sell in January to get more effect out of their losses. But interestingly his thesis is layered on top of a tacit admission that the January Effect is real, even though he thinks it will be suffocated this year by the financial dislocations of late 2008.
Associate editor Jack Hough writes in December’s Smart Money that he is “not sure whether this year is shaping up to produce the mother of all January Effects or none at all.” He also suggests that it would not be a good idea to buy shares in a company you would not otherwise want to own just to benefit from an anticipated updraft from the passing-by of Father Time at midnight on December 31, though he recommends having a serious look at closed-end muni funds. http://www.smartmoney.com/investing/stocks/a-january-effect-play-you-havent-heard-of/
Not surprisingly, Mark Hulbert weighed in on MarketWatch just before Christmas, on December 22. http://www.marketwatch.com/news/story/january-effect-worth-betting-year/story.aspx?guid=%7BDC190815-84C4-4704-A6FA-7CBBE2B4A563%7D His opening salvo says it all: “Ordinarily, I would feel comfortable urging you to consider a strategy over the next couple of weeks that attempts to exploit the so-called January Effect. But, as is abundantly clear, we are not in ordinary times.” He does point out that “it is one of the strongest historical patterns that researchers have ever documented in the stock market.” He also discusses a phenomenon that I have noticed over the years, that fund managers’ appetites for risk increases dramatically in the first few months of a calendar year, attributing it to comp-related reasons (which I agree with). He also points out that the 2008 version of the January Effect was far from pretty (he does not quote a number, but I believe stocks lost 6% or so overall last January).
Hulbert says that December 20 is sometimes seen as the entry date for January Effect investing, and that January 9 might be an exit.
Finally, there was an interesting session on CNBC’s “Fast Money” on Christmas Eve, http://www.cnbc.com/id/28381942?__source=RSS*blog*&par=RSS with John Roque of Natixis Bleichroeder predicting gains yet in 2008 (and some Bronx cheers coming back). In that same program Jeffrey Hirsch of Stock Traders Almanac http://www.stocktradersalmanac.com added that he thinks we should keep our eyes on a “Jack Frost” rally (his moniker for a January Effect). “January is the first month of the year, when people set their forecasts. And there’s the state of the union address and important agendas laid out,” he says. “All those things set the tone for the year.”
As with most crystal-ball-gazing, the future is a bit cloudy. But my research shows general agreement on a tendency for equities to rise in January. Like I said at the top, it is probability that drives investments. If the sense of optimism, single-mindedness and pragmatism that President-elect Obama exudes is contagious in the financial world – or the retail stock world for that matter – we could see a January Effect that is more than a short-lived bounce. And it may set the pattern for the year to come.