Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Tuesday, Jan. ... [+]
January is probably the most unique month in the stock market. Returns are often higher than for other months, and volatility can rise too. Furthermore, momentum, which is often a solid strategy month-to-month, can misfire in January and small-cap value investments frequently have an exceptionally strong month. So January has a lot going on for investors, but it this real or is this just data-mining? More importantly, what might we expect this year?
The Causes Of The January Effect
We don’t fully know what causes the January effect. Still, we have a few ideas. The end of December marks the end of the tax-year and a key reporting period for fund managers to their investors and banks to the regulators. So there’s a lot going on at the end of December, this could indirectly drive trading behavior.
First off tax-loss harvesting. For retail investors it can be helpful to sell your losers before the end of the year and thereby realize a tax-loss. Now there’s good reason to spread this sort of trading over the full year as that leads to more opportunities to do it. Still, many seem to leave it to the last minute and get it done in December. This potentially creates downward price pressure on poor performing stocks, because those are the candidates for short-term taxable losses. Hence, theory suggests that value stocks with poor momentum can have a good January as they rebound from being sold for tax purposes in December.
Secondly, window dressing for fund managers may impact the markets in January. Typically holdings are disclosed at year-end. Holding a stock that has declined over the year may look bad for the fund manager. Hence, there’s an incentive to dump it before year end and keep the winners in the portfolio. Once January rolls around, the disclosure period is complete and the fund manager can once again buy back into the ugly names where they have conviction, despite rocky recent performance.
Thirdly, January may also see a stronger variation on the turn of the month effect. Stocks can lag at the end of a month as market participants need cash to improve their regulatory reporting or have cash on hand to fund redemption needs. Then, early the next month, money flows back into the markets. The turn of the month effect can be powerful according to research by Laurens Swikels and Pim van Vliet. Plus, it may be stronger at the turn of the year too where it intersects with the Halloween indicator. It’s also possible this effect is stronger this year due to the disruption in the repo market and relatively recent regulatory changes for banks. Given the disruption we saw in the repo market this September, it will be interesting to see what the next quarter-end period of December holds.
Not Guaranteed
Nonetheless, the January effect is far from guaranteed, the effects tend to play out somewhere between six and eight years out of ten based on history. So to put it another way, there’s a good chance the effect doesn’t play out at all. You may make money over time, but that’s very different from making money consistently every year. Also, consider that this effect is becoming more broadly studied and that too, may diminish its impact in future years.
How To Play It
So if the January effect were to occur play out this year, here’s how you might set up for it. You would load up on small-cap value stocks in late December, typically those that have had a bad 12 months in terms of their historic performance in absolute terms and relative to other stocks. You would then also take any momentum bets off the table for January because the strategy tends to be much weaker for the month. Finally you might try and increase stock exposure for the first few days of January to benefit for the turn of the month effect, which can often be positive. Although, volatility can be higher too.
Of course, all of this short-term trading can result in bid/ask spreads and tax consequences that could offset any benefit. Even in a good year, the January effect is worth perhaps a few percentage points of return. That’s easily lost with an inefficient trading strategy. Still as calendar anomalies in the markets go, the January effect is often considered one of the strongest out there, so it will be interesting to see how it plays out this year.
https://www.forbes.com/sites/simonmoore/2019/11/24/should-you-take-advantage-of-the-markets-january-effect/
2019-11-24 14:54:01Z
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