January Effect – Fact or Fiction?

January may be the time to buy small stocks

The stock market is all about numbers and cold-blooded decisions, so it is rather obvious that they do not mix well with emotions and superstitions, right? Wrong. The securities industry has its own phenomenons that are difficult to explain or justify, and yet investors fall for them. Just think of the adage sell in May and go away, also known as the Halloween Indicator. We may also take a look at the January Effect that exists based on investors’ logic and calculations rather than facts.

Known for decades

The January Effect is based on a pattern that has existed for many decades. It all started in 1927 when it was noticed that, in January, weaker and smaller stocks do better than stronger and larger ones. According to research done by two professors from the University of Kansas, Mark Haug and Mark Hirschey, every January between 1927 and 2004 those small stocks outperformed the large ones by 2.5 percent. The researchers also noticed that expensive stocks were losing to the cheaper ones by 2.4 percent.

Why does it happen?

All right, then, so we know what happens on the stock market in January, but why does it happen? Well, a logical explanation of the January Effect is that as the year’s coming to an end, investors sell small stocks in order to generate tax losses, and then they buy back the same stocks in January. As a result, small caps have a superficial price boost that makes their performance much stronger in the first month of the new year.

Does it stop happening?

The trend is clear and obvious, or at least it has been up until a few years ago when analysts really began understanding it. “If everyone starts doing something, the strategy’s effectiveness will be reduced,” explained Sudhir Nanda, a portfolio manager at T. Rowe Price Group in Baltimore. And so the January Effect kept fading as the years went by. The out-performance of small caps decreased from 5.1 percent during the 1970s to a single point during the 1990s.

It is difficult to argue with Nanda’s explanation, but there may be one more reason for the January Effect to become less popular among investors. Nowadays an increased number of people turn towards tax-sheltered annuities and therefore do not need to look for opportunities to create tax losses at the end of the year.

Shift in time

It does not mean, however, that the trend ceased to be. It still exists but its timing has slightly changed. These days, investors often attempt to offload small stocks and generate tax losses as early as the end of October. The shift in time, which has become easier to spot in the first decade of this century, resulted in small caps doing well even before the new year. “There wasn’t much of an advantage from 2002-06, although from 2007-09, small caps did well in the last two weeks of December, posting gains two to three times bigger than large caps,” noticed editor-in-chief of the Stock Trader’s Almanac, Jeff Hirsch.

Will it go away?

There is no doubt that the January Effect is no longer what it used to be. The name becomes increasingly misleading but will probably forever remain an inevitable part of stock market lingo. Pankaj Patel, a strategist at Credit Suisse, predicts that the phenomena may simply find a new time frame. “Investors might be able to boost performance by buying the stocks in mid-November, to avoid the worst of the under-performance by weak stocks, and selling in mid-January, to avoid the rush of sellers,” he says. As we see, the existence of this phenomenon is a fact but timing becomes a fiction.