January Effect

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The January Effect: Bull or BS?

by Mark Skousen, Chairman, Investment U
Thursday, December 29, 2005: Issue #498

Most of you have heard of the January Effect. But actually, there are three versions:

Stocks do better in January than any other month.
What happens in January predicts what will happen to stocks for the rest of the year.
Small stocks do better than large stocks in January.

There’s actually a shorter version of all three January Effects, i.e., the last day of trading in December and the first five days in January are supposed to be especially strong.

Let’s Test Each January Effect Hypothesis with the Facts:

#1 – January Isn’t the Only Good Month

This January Effect is historically true 70% of the time since 1900. But lately, January bullishness is not automatic. Since 2000, stock performance (as measured by the Dow) in January has been anything but predictable: up in 2000; down in 2001; down in 2002; down in 2003; up in 2004; and down in 2005.

I don’t think you can count on January to be an automatic up month anymore.

Also, it should be noted that stocks also do well in other months. On average, there are three months where stocks perform consistently well on Wall Street – January, April and December. In fact, stocks have done better in December than January recently. The Santa Claus Rally has become more powerful than this January Effect.

The chart below shows month-to-month seasonal trends in the Dow.

#2 – January as a Forecaster

What about January Effect #2? Most of the time, this is true, but only because historically stocks have been in a long-term bullish trend over the past 100 years, so January is likely to be a rising month, too.

Again, lately, January can’t be relied upon to predict the entire year. Examples: In 2000, January was bullish, but the markets, especially the Nasdaq, tanked starting in April. In 2003, January was bearish, but stocks recovered sharply later in the year.

#3 – Russell 2000 Better than Dow 30?

Finally, what about January Effect #3, that small-cap stocks outperform large-cap stocks in January? Again, this has historically been proven to be true since 1900. According to Jeremy Siegel’s classic work, Stocks for the Long Run, small stocks have outperformed large stocks 80% of the time (2nd edition, p. 300).

But wait! Lately, the record is mixed. From 1994 to 2000, small stocks lost out to large stocks every year. Then, starting in 2000, small stocks returned to form, winning the race three out of five times (2001, 2004, and 2005). Obviously, there’s no guarantee or high percentage that 2006 will live up the January Effect #3.

Lessons from the January Effect: Stick With the Fundamentals

We can learn an important lesson from studying the various types of January Effects.

First, there are indeed anomalies in the stock market, due to the effects of tax laws, the way earnings are reported by major corporations, seasonality in consumer and business spending habits, etc.

Second, market response to these anomalies is important. The key is to take advantage of these anomalies early, before they become generally known. If everyone becomes aware of the January Effect, it will lead to investors buying early – hence the Santa Claus Rally.

Always remember that behind all markets are human beings who buy and sell for a variety of reasons. They are constantly learning from new knowledge and mistakes of the past. Thus, there can never be a “sure deal” in investing or a “perfect” investment over the long run. Too many people find out about the “sure deal,” and when they smell money, above-average returns turn into below-average returns.

I saw this with the “Dogs of the Dow” strategy that was so popular in the early 1990s. At first, only a few insiders recognized that the 10 highest-yielding Dow stocks outperformed the market indexes. But then somebody published a bestselling book about this technique, and then all the major brokerage firms started offering “Dogs of the Dow” managed accounts. Suddenly, the strategy stopped working.

The January Effect may be one of the casualties of excessive popularity on Wall Street. Best to stick with fundamentals to make money in the marketplace in 2006.

Good trading, AEIOU,

Mark

Today’s Investment U Crib Sheet

As I mentioned above, there may be a market phenomenon more powerful than the January Effect See InvestmentU # 490: The Santa Claus Rally.
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