Looking for the January Effect
Eileen St. Pierre, The Everyday Financial Planner
Given the impact the presidential election has had on the stock market, I wanted to re-release this column that was originally published two years ago. As we approach the end of 2016, expect to hear financial reporters talking about the Santa Claus rally and the January Effect. The January Effect refers to an anomaly in the stock market when stock prices tend to increase in the month of January. This effect has impacted small cap stocks more than larger cap stocks.
“Cap” refers to the market value of the stock = stock price x # of shares outstanding.
What causes the January Effect?
Reversing tax-loss selling is given as the most common reason for the existence of the January Effect. Here’s how it works:
- In December, investors may sell stocks to generate capital losses.
- They then buy these stocks back in January.
- Since small cap stocks have fewer analysts following them than the larger stocks (like Apple) and are considered less liquid, there is greater potential for an increase in their stock prices when investors buy these stocks back.
Another reason for the January Effect is keeping the New Year’s resolution to save more money. If this holds, don’t expect the effect to last for very long – we all know how quickly resolutions are broken.
The January Effect is not as pronounced as it used to be.
When I was in graduate school in the early 90’s studying for my Ph.D. in Finance, I had to read all the academic articles regarding the January Effect. Don’t worry, I won’t mention them here. However, by the time I graduated in 1993, the January Effect had shrunk in time from the first week in January to the opening hours of the stock market on January 2.
Since then, the markets have priced in the January Effect. With the shift from pensions to 401(k)s and other defined contribution retirement plans, many investors hold their stocks in tax-deferred accounts so they do not need to worry about tax-loss selling.
Some say stock market performance in January predicts the rest of the year.
Businessweek looked at the correlation between stock market returns in January and annual returns. Using 85 years of S&P 500 data, they found a correlation of 0.30.
- Five other months (April, May, September, November, and December) had stronger correlations with annual returns. September had the highest correlation at 0.58.
- Using 35 years of Russell 2000 data, which many use as a benchmark for small cap stocks, they found a correlation of 0.40. Two other months, July and September had higher correlations.
- The takeaway from looking at these two datasets is this – September, not January, predicts the rest of the year better than any other month.
How can you take advantage of the January Effect?
As I mentioned in last week’s column Ho Ho Ho: Is the Santa Claus rally on its way?, the best way to capture these short-term price increases is to be properly invested in stocks for the long-term. If you have established that you want 60% of your retirement to be in stocks and the other 40% in bonds, then you will automatically reap the benefits of the January Effect if it occurs.
The bottom line is this – don’t try to time the market by flipping small cap stocks on January 2. Do something more worthwhile like playing in the snow with your kids.
Visit my Basic Financial Management page for more information.