The January Effect Explained

One of the few universal truths on Wall Street that we are aware of is that “to know what everyone knows, is to know nothing.” In other words, if it really was easy to make money in the markets, then everyone would be a millionaire by now. And, since only about 9 percent of U.S. households report a net worth of at least $1 million (according to TNS, a marketing research firm), there are many stock market investors who are not millionaires.

The January Effect is the widespread belief that stocks tend to rise during the first month of the year, and in particular during the first week. The most popular theory for why this happens is that many investors choose to sell losing positions at the end of the year so they can claim a capital loss for tax purposes. In January, these cash-rich investors try to put their money back to work in the market, causing stock prices to rise.

This phenomena has been widely studied. (See, for example, Mark Haug and Mark Hirschey (2006). "The January Effect." Financial Analysts Journal, 62:5, 78-88.) It has been documented that since 1802, stocks have a tendency to move higher in January. The research concludes that small cap stocks are the best performers, and simply reviewing the academic literature could lead us to buy an ETF such as the iShares Russell 2000 Index (IWM) and hope for a profit.

We find academic research is best used as a starting point for investing ideas. To begin finding an investable idea, we wanted to know how often the first week of the year is higher for the various stock indexes. Using all available data, the results are summarized in Table 1.

Index	Percent of time first week of year closes higher	Percentage of all weeks closing higher
Nasdaq Composite	66.7%	56.5%
S&P 500	56.8%	55.7%
Dow Jones Industrial Average	54.2%	55.9%
S&P 400	47.1%	56.9%
Russell 2000	40.0%	52.4%

Table 1: A comparison of the percentage of the time various indexes close higher in the first week of the year to the percentage of up weeks in their history.

Table 1 shows that the NASDAQ composite index has a history of outperforming in the first week of the year, but the Russell 2000 actually performs significantly worse over that time frame. Monthly results are shown in Table 2.

Index	Percent of time stocks close higher in January	Percentage of all months closing higher
Nasdaq Composite	79.2%	63.8%
S&P 400	76.5%	62.6%
Dow Jones Industrial Average	60.7%	57.2%
Russell 2000	60.0%	57.5%
S&P 500	58.0%	57.3%

Table 2: A comparison of the percentage of the time various indexes close higher in January to the percentage of up months in their history.

We can see in Table 2 that the January effect is most pronounced in the speculative NASDAQ Composite and Midcap stocks. These results show the value of testing conventional wisdom.

The performance of the NASDAQ Composite index is largely driven by the biggest names within that index. At the beginning of the year, investors often review a list of the best performing stocks from the previous year and may be buying last year’s tech winners. The Midcap index is an underfollowed group of stocks that typically fare better than small cap stocks. They have survived the often-difficult start up phase and are more likely to be thriving businesses. These stocks are also more likely to be found on the list of last year’s top performing stocks.

In other words, based upon this simple research, we can conclude that relative strength partially explains the January Effect in stocks. Recent performance often drives investor behavior. Rather than trying to select the best stocks, a difficult challenge for even the professionals, ETFs offer a practical way to implement these ideas.

Comments

[skwestorange:]

What the tables really convey is that for all indices, any week or month has just much of a chance being up as any other week or month.

2008 Dec 25 11:43 AM

[PeakOiler:]

What I'd really like to see is another dimension: prior year where market gained, prior year where market dropped <=5%, prior year where market dropped > 5%. I would expect the January effect to be larger in the latter category, and weakest in the first category. Michael, would this be possible for you to compute? Thanks for the article.

2008 Dec 25 12:35 PM

[Mike Carr:]

I am trying to work on that actually and hope to have it within a week.
Thanks, Mike


On Dec 25 12:35 PM PeakOiler wrote:

> What I'd really like to see is another dimension: prior year where
> market gained, prior year where market dropped <=5%, prior year where
> market dropped > 5%. I would expect the January effect to be larger
> in the latter category, and weakest in the first category. Michael,
> would this be possible for you to compute? Thanks for the article.

2008 Dec 25 05:19 PM

[Syl:]

After reading the article I have decided to wait until the market settles down more into February. Thanks for explaining your theory.

2008 Dec 25 06:49 PM

[Lenaa:]

MAYBE IT IS NOT A GOOD NEWS FOR ME, BECAUSE I AN A CONSULTING COMPANY.
THOUGH PEOPLE WILL NOT STOP THEIR EXPANDING IN THE WORLD, THEY WILL SLOW DOWN THEIR STEPS. IT IS SERIOUS FOR ME.

HOWEVER, IF WHO WOULD LIKE TO ESTABLISH A COMPANY OR OFFICE IN CHINA, I WILL GIVE ALL MY HANDS...

2008 Dec 25 10:11 PM