foxex: The January No-Effect

Chart Advisor | Focus on the Price

By Gordon Scott, CMT

Monday, December 30, 2019

1. Historic market moves in January

2. The confounding of the January Effect

3. Trading the January Effect

Historic Market Moves in January

As far back as 1942 there is a record of people discussing the so-called January Effect. The earliest expressions of this idea were related specifically to small cap stocks outperforming large cap stocks in the month of January. Later versions of the phenomenon were expanded to discuss the propensity for stocks in general to rise during that month.

The data seems to indicate that there is attractive evidence to adopt this notion. For example, the pie charts below detail the percentage of the times that stocks in the S&P 500 index (SPX) close higher for a given month out of all months since its inception in 1928. It does indeed appear that stocks do tend to rise more frequently than they fall during January, and even more so than other months by comparison.

The Confounding of the January Effect

In 1973 Princeton Economist Burton Malkiel published a popular book titled "A Random Walk Down Wall Street." This popular book is still in print after 15 editions with more than 1.5 million copies sold. Within its pages Malkiel lays out the case that the so-called January effect is a non-starter. What is surprising about this claim is that at the time Malkiel first penned this observation, it was a good bit less obvious to detect than it is now.

Even today the returns from buying in January and holding until the end of the month look pretty good compared to other months if you include all the data going back to 1928. However, if you zero in on the last 30 years, this advantage seems to dissipate (see tables below), thus proving the author's original point.

Read more:

Making Sense Of Market Anomalies

7 Market Anomalies Every Investor Should Know

The Small Firm Effect

Trading the January Effect

The fact remains that for whatever reason, broad-market stock indexes tend to close higher than they open more often than not during the month of January. As it turns out there is one additional indication that can help traders sort through whether January is more or less likely to be a positive month, namely the returns of the previous month.

Looking back at the last 91 years of data for the S&P 500 index, we can see that if the index closed higher than it opened in the month of December, the month of January was twice as likely to be a positive month. By comparison if December closes lower, January is a coin flip. This trend appears to persist even in the last 30 years. The average gain for January when December is positive is 3 percent for the month.

However it should be noted that the average loss for the month is -4.5 percent. Combining these two measures and adjusting for probability amounts to an expected return of zero. (Fans of the Efficient Market Hypothesis will undoubtedly cheer at this news.)

So that means traders who look to make use of this observation will have to be a good bit more strategic than merely buying and holding through January if December is positive. Hunting for market lows mid-month in January, heading into earnings season, is likely to pay off well for careful traders who manage their risk appropriately.

The Bottom Line

The January Effect appears to have some evidence to support the notion that stocks rise early in the year. However exploiting this perceived anomaly is indeed illusory. Observing whether the previous month has had a positive return may be of help to careful traders who look to make timely entries midway through the month of January.