Chart Advisor: January Effect

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Tuesday, 28th December, 2021

1/ History of the January Effect 

2/ Does the effect cancel out?

3Tactics for trading 

4/ The bottom line

1/ History of the January Effect 

With the year 2021 ending, investors may find it worthwhile to look forward for a well-known occurrence called the January Effect. The focus of the literature documenting this investing anomaly changes over the years, but there is little dispute that such a phenomenon exists. 

As far back as 1942, there is a record of people discussing the January effect and looking for ways to exploit it. 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. Perhaps because this seems like a logical thing to expect of the markets, it tends to be more frequently considered than necessary.  

It is true that 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. It does indeed appear that stocks tend to rise in January more often than they do across an average of the other months. 

2/ Does the Effect Cancel Out? 

In 1973 Princeton economist Burton Malkiel published a popular book titled “A Random Walk Down Wall Street,” which took this notion to task. His 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 Malkiel’s claim is that when he first penned these observations, the difference between January performance and other months was easier to see than it is now. 

Interestingly, if you zero in on the past 30 years, this advantage seems to dissipate (see tables below). Malkiel would have had an easier time making his case today than he did back in 1973. But even if stock performance in January isn’t stronger than in other months, it doesn’t mean the data shows no difference. 

3/ Tactics for Trading 

The fact remains that, for whatever reason, oftentimes broad-market stock indexes tend to close higher than they open 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 past 93 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 past 30 years. The average gain for January when December is positive is 3% for the month. Should December manage to close out 2021 in positive territory on Friday, it sets the stage for investors to expect a pleasant start in 2022. 

Traders could look to use their rules for the Santa Claus rally to get an early start on trading the January effect. By simply extending the trade to 30 days rather than six, and trailing a stop-loss order higher, an active trader can capture good performance in the month should the effect play out as hoped (see chart below). 

However, it should be noted that the average loss for the month is 4.5%. Combining these two measures and adjusting for probability amounts to an expected return of zero. Proponents of the Efficient Market Hypothesis might be justified adding an “I told you so” right here. 

This 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. 

4/ 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 illusory anomaly requires a strategic approach 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. 

Originally posted on 28th December, 2021

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