What is the January effect and is it real?

What is the January effect?

The January effect is the theory that there is a seasonal increase in the prices of company shares during the first month of the year. The hypothesis is based on the idea that markets are inefficient and so experience seasonal anomalies. If markets were efficient – based on the real price of an asset – the January effect would not exist.

This calendar anomaly was first noticed in 1943 by investor Sidney Wachtel, who saw that small-cap stocks had outperformed the wider market most Januarys since 1925. Since this discovery, there was a widespread belief that the shares of smaller companies would outperform other months in January, especially in the middle of the month.

The January effect is often specifically focused on small-cap stocks. There is a belief that this is because they are commonly part of a retail investor’s portfolio, and it is these investors who are more likely to sell in December and buy again in January. It is thought that small-cap stocks are less liquid than mid or large-cap stocks, so are susceptible to sudden and rapid movements in price.

Learn more about market anomalies

What is the January barometer?

‘The January barometer’ is a term often used synonymously with the January effect, but can be seen as an additional part of the theory. The concept follows the popular saying that ‘as goes January, so goes the year'. It is a belief that the direction the stock market moves in during January defines whether it will rise or fall for the remainder of the year.

The January barometer is focused on US stocks, specifically the S&P 500. The hypothesis is that if the S&P 500 rises in January, it will rise throughout the year, and if it falls in January, it will decline for the rest of the year.

This ‘other’ January effect has been heralded as a guide to trading and has regularly made news headlines. The stock market does generally have an upward trajectory over long periods of time, which is perhaps why the January barometer is a popular theory. But behind every market folklore is a plethora of stories that demonstrate that the anomaly does not work and should not be used as the basis of a trading or investment strategy.

What causes the January effect?

The most commonly cited reason for the January effect is that the stock market is bouncing back from a fall it experienced in December, though there is still a lot of debate about whether the effect is real. According to the theory, there is a sell-off in December that is caused by investors and traders closing their positions for tax purposes – mainly to offset capital gains against any capital losses. After 1 January, these market participants then re-enter the market and cause January’s rise in prices.

Another theory goes that many individuals who receive Christmas bonuses at the end of the year choose to use this money to trade or invest in stocks, which could also drive the prices up in January.

However, beyond these explanations there is a strong case for the January effect simply being a result of trading psychology. The new year brings about increased positivity in the stock market, as there is a widespread belief that January is the best month to open new positions and many even have resolutions around making money.

It is also likely that the January effect has become a self-fulfilling prophecy – people think that share prices will rise, so buy shares in the hope of capitalising on this increase and push the prices up.

Is the January effect real?

The debate about whether the January effect is real has been ongoing since it was first noticed by Sidney Wachtel in 1943. Although there has been a belief that these market anomalies are an inevitable part of the market cycle, in recent years, the market has seemingly adjusted to this anomaly. This has caused the validity of both the January effect and the January barometer to be called into question.

New studies have shown that the January effect has lost a lot of its persuasiveness. Recently, Goldman Sachs released a study that looked at the European stock market returns from January 1999 through to 2017, which concluded that the January effect had faded when compared to figures from 1974. The data showed that the average performance for the stock market in January was -0.5% compared with +0.2% for all other months of the year.1

This analysis showed that January is not necessarily a special month in terms of stock market gains, and traders should be wary of using such a short window of data as a basis for any longer-term strategies.

Despite being a popular theory, the January barometer hasn’t held up to examinations either. In fact, over the ten-year period between 2008 and 2018, it’s track record is about 50:50. The January barometer has predicted the direction of the stock market correctly five times and has been wrong five times. Essentially, using this anomaly as a strategy gives you the same odds as flipping a coin.

The accuracy of these calendar anomalies is still very much up for debate. In theory, the January effect ‘worked’ as recently as January 2018, when the S&P 500 rose from 2664.34 points in December 2017 to 2789.80 points the following month. This created a buzz that the bullish market anomaly was alive and well, but that is where the accuracy of this hypothesis ends. As although the S&P 500 did rise throughout the year, it experienced significant declines from the end of October through to December – disproving the barometer.

Should traders take notice of the January effect?

It is always worth traders being aware of market anomalies, due to the power of market sentiment in causing trends – if enough people believe in the effect it could cause price movement.

But while the January effect and the barometer are attractive theories, they don’t necessarily hold up over time. It can be easy to get swept along in the speculation surrounding calendar anomalies, but it is a risky way to place trades, as there is no guarantee that the market will follow these anomalies year after year.

This is not to say that there are no patterns in the stock market. But it is better to create your own trading strategy and carry out your own fundamental or technical analysis, than to base your trades on market anomalies.

1Fortune, 2017