13 Jan The January Effect: Does it matter in 2016?

by Wechter Feldman Wealth Management

The January Effect

The January Effect is a pattern exhibited by stocks in the last few trading days of December and the first few weeks of January. During this period, particularly starting in January, the theory is that stocks tend to rise.

In simple terms, the January Effect is a consequence of tax-loss selling, in which investors sell stocks that lost money at the end of December, in order to take losses as tax deductions. Because so many of these stocks that lost value were sold in late December, they will be – in theory – available at a discount in early January. Another purported cause of the January Effect is the payment of year-end employee bonuses, which employees may invest in the stock market. As a result, investors with more money to invest end up buying cheaper stocks, making the market more active.

Studies Confirm: The January Effect is not just a Wall Street myth as several prominent studies have confirmed its existence. One study of historical data from 1904 through 1974 discovered that the average return during January was five times larger than the average return for other months. Another study showed that small cap stocks (as represented by companies in the Russell 2000) outperformed large cap stocks (as represented by companies in the Russell 1000) by 0.8% in January, but lagged behind large caps for the rest of the year.

From 2000 to 2014, however, the results were mixed: In seven years, there were January gains, but in eight years, the market lost ground during the month of January.

Effect Becomes Less Effective

In recent years, the January Effect has become less pronounced. As a result, it is a less effective way for investors to take advantage of the market. Once investors, economists and traders spot, analyze, and confirm the existence of a trend, it tends to become less pronounced.

Investors “price in” the trend, adjusting their investment strategies to take trends (like the January Effect) into account. Another reason that the January Effect is less important is that many people now use tax-sheltered retirement plans, like IRAs and 401(k) plans. When investments are tax-sheltered, there is no tax advantage to sell a stock for the purpose of deducting losses.

So what about January 2016?

Global markets tumbled on January 4th, the first day of trading in 2016. Key factors included concerns about slowing economic growth in China and rising tensions in the Middle East. The Dow lost 1.6%, the S&P 500 fell 1.5%, and the Nasdaq Composite Index declined 2.1%.

From January 4th through January 7th, the Dow fell over 5%, the worst 4-day start for the Dow ever, going back to 1897. The Nasdaq was down 6% over these days.

What does this start mean for the rest of 2016?

Using January to Predict the Rest of the Year

The January Effect is not only a money-making opportunity for astute investors. Many investors and analysts have tried to use it for predictive value.

However, there are different questions about these predictions.

How well does the first day of January predict annual market performance? Not very well. Based on data from 1962 to 2015, a bad first day leads to a bad year only about 28% of the time.

How well does the first week of January predict annual market performance? Somewhat better. From 2000 to 2014, the first week of trading has predicted the stock market’s annual return 67% of the time. From 1962 to 2015, however, a down market in the first week accurately predicts a bad year only 50% of the time.

How well does the entire month of January predict annual market performance? About as well as a monkey making a coin toss. From 1962 to 2015, a below-par January accurately predicts a bad year only 55% of the time. A lagging January 2015 did predict a lagging year, however. In January 2015, the Dow Jones Industrial, S&P 500, and Russell 2000 indexes each suffered losses of 3% to 4%. At the end of 2015, the Dow had fallen 2.23%, the S&P 500 lost 0.73% and the Russell 2000 fell 5.71% for the year.

As these numbers show, the January Effect is simply not a very good predictor of annual stock market performance. Of course, the S&P 500 has risen 7.6% on average from 1962 through 2015. As a result, negative omens in January are generally more likely to fail than succeed.

Conclusion

Having a monkey toss a coin might work just as well as using January data to predict yearly performance. A bad first day, bad first week, or bad first month simply do not tell us much about how the market will perform over the course of the year. Every year has hundreds more trading days, 51 more trading weeks, and 11 more trading months. So many different economic, political, weather, and other factors can pop up at some point during the year. Current concerns about the Chinese economy and Middle East strife will be replaced by other concerns, and positive economic news will also gain prominence.

The initial market results for 2016 matter. Investors should not ignore poor market performance for individual stocks or market segments. When it comes to predicting how markets will perform for the rest of the year, however, results in January appear to be no more important than results at any other time.

Many factors affect the financial markets. Be sure to consult your Wealth Manager for specific guidance.

Michael Green is a certified financial planner with Wechter Feldman Wealth Management in Parsippany, He may be reached at    or (973) 605-1448.

This story was first posted in January 2016.

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