Two weeks in the new year. The past has been reflecting, lists have been maid and we have committed ourselves to new goals. But there is something else that reoccurs every year in January… The January Effect.
This phenomenon refers to the rise in stock prices in this particular month and the bullishness of the stock market in a whole. We all have harder times finding dividend stocks for a good value the past few weeks. Might this effect have something to do with it?
For years and years there are several well-known tendencies at the stock market at reoccurring periods of time. One of them is the January effect, or the notion that the first month of the year is always bullish for stocks.
Where does this effect come from?
It’s connected to a strategy which is most used at the end of every year: tax-loss selling.
This strategy is mostly implement during the end of december, but can be used every time of year. Where an investment (with an unrealized loss) is being sold. And sometimes replaced by an asset with similar risks and return levels. Hereby investors try to limit the recognition of short-term capital gains and are aiming on reducing taxes.
Because this is a strategy implemented by many investors, the prices in the markets will go down. And only because investors want to reduce their tax expenses, not because a company doesn’t perform well or due to macro-economic events. Of course this is not the only reason to sell or replace a stock. But strangely, every year many investors hold on to this. So the idea is that some, or even most of the stocks are sold because of tax-loss selling. Resulting in assets (not only stocks) trading at prices lower than their estimated fair value.
Want to know more about tax-loss selling? Then check out Investinganswers.com where you can find a nice detailed definition.
Then one month later, another phenomenon kicks in: The January Effect.
This effect is simply referring to an anticipating gain in stock prices, just because it’s the beginning of the year. And the expectation of a bounceback from tax-related selling.
So in december investors sell stocks in order to reduces their taxes, while in January they buy back other stocks in order to find capital gains elsewhere. One other factor that could drive up the markets in January is people who are getting a bonus paid in december or maybe even the new years resolution to get your financials on track. Even the theory itself could drive up the markets, resulting in a self-fulfilling prophecy.
Should we wait till the markets come at ease again before we make any new buys? Or are we just too late to step in this time of year?
There is one thing you should not do. Timing the market. We simply can’t time the market, maybe no one can. Because if we could, then wouldn’t everybody profit of this January effect by buying before and selling in the middle of this trend?
The January effect as an inconsistency in the market
Security markets are thought to be the most efficient of all markets. Which can only be true by assuming that investors make rational and well-defined choices. However an economic anomaly, like the January effect, contradicts this phrase. An economic anomaly is a form of market inefficiency and is inconsistent with the present economics pattern. Research (by Thaler) shows that the January effect is an economic anomaly.
If the January effect was happening every year, it would be part of a pattern. A pattern which we could see in the data of market returns. So let’s take a look there.
In the below graph the return in January per year is selected based on the performance of the S&P 500 starting in 2006.
For the past ten years, 6 of them had seen negative returns in January. While only 5 of them had a positive return. Based on this, you could say that the January Effect is a hoax.
Research is showing that the average return in January was higher than the other months of the year, might be partially to blame on luck. The years being researched probably did have higher returns in January. Thereby saying it will happen every year, is only working when one assumes that the markets works in a predictable way. And it just doesn’t.
It’s the same with the example I’m showing you above. The given returns are only of the years after 2005. What happened before? Is this image not just the same ‘luck’ of proofing the January Effect is non existing? The January Effect has emerged way earlier and its said that the market on average is true to this effect over a very long timeframe. It just could be that this effect has lost it’s glory days in the modern days. Maybe lower interest rates, quantitive easing and some crises had their impact.