A Review of the January Effect

Although it may be hard to believe, we are in the final stretch of 2019. As of market close on November 14th, there are just 31 trading days left in the year. As subscribers to AVC-Pro are already aware, there are several market tendencies or historical biases that we highlight throughout the year.  In many cases these are observations that have been documented over time within one of our favorite trading resources, the Stock Trader’s Almanac; and include items such as market seasonality, the “January Barometer,” and even performance patterns surrounding presidential election years.

Another historical tendency worth noting at this time of year is the “January Effect.” The “January Effect” refers to the tendency of small cap stocks (as a group) to outperform their large cap counterparts early in the calendar year. However, when any seasonal trend becomes widely accepted, we tend to see the market adjust accordingly. In the case of the January Effect, we have seen this phenomenon move sooner in the calendar over the years.

According to the Stock Trader’s Almanac, “In a typical year, the smaller fry stay on the sidelines while the big boys are on the field.  Then, around early November, small stocks begin to wake up, and in mid-December they take off.”  The reasons are debatable, but the historic tendency is not. Consider the table below, which examines the last 22 years of market activity, and the results of a theoretical $10,000 portfolio that would invest each year in the standard “January Effect” move. Accordingly, this table reflects the returns of someone buying the Russell 2000 Small Cap Index (RUT) and selling the S&P 500 (SPX), capturing the spread between the two.

The first table shows the returns of someone entering this trade (based upon the closing price of each index) at the end of a year, and holding the position through the end of January. The results show no significant bias toward small cap outperformance, and actually shows a negative average return for both indexes. The second table, however, captures the hypothetical returns of someone taking the same approach, but entering the trade in the middle of December, and holding through the middle of January.

Although this trend has not played out in the three most recent years, over the long-term this holding period shows a clear bias toward outperformance by small cap stocks; serving as evidence that the “January Effect” has become as much a “December Effect” in recent years.

, A Review of the January Effect
The January Effect is most effective if traded from mid December

Here are some points to keep in mind with respect to the January Effect:

  • Lagging money managers who fear for their jobs will cut their losses in small cap stocks and invest in blue chips to avoid ending the year at the bottom of the performance rankings. They will then look to re-establish their aggressive positions in January, thereby helping fuel small stocks on a relative basis.
  • Small stocks tend to outperform the rest of the market during the year’s first month, a trend that has become more prominent over time from the middle of December through the middle of January.
  • The lower the institutional ownership of the stock, the greater the January effect, suggesting that individual trading is most responsible for the effect. This makes sense in that taxes have a greater impact on individual investors than institutions.
  • The years most likely to experience a pronounced effect are those preceded by large losses in the prior year, suggesting tax-loss selling is a key driver to this effect.
  • The effect tends to be greater when the US dollar is strong, and weaker when the dollar is declining.
  • Year-end bonuses, distributions, and gifts may go into the market, providing a boost in demand early in the year, the major effect coming from corporate retirement plans.
  • Money managers are more likely to place riskier bets in the beginning of the year, but bring their portfolios closer into alignment with the S&P 500 as the year progresses to protect themselves from any major deviation from their bogey late in the year. Risk Tolerance is typically relaxed at the very end of the year, and more so into early-January.