Everyone Trading Stocks pays attention to the “January Effect”

Everyone Trading Stocks pays attention to the “January Effect”

Everyone Trading Stocks pays attention to the “January Effect”

Is this another self-fulfilling prophecy or a trap for traders

Just like the “Santa Claus rally”, the so-called “January Effect” is used to describe the rise of stock market indexes in the first month of the year. The term was coined in 1942 by the economist Sidney B. Wachtel. Just like the one between Christmas and New Year’s Eve, the January Effect is mainly explained by year-end tax reasons, but its occurrence has been less frequent of late.

The effect is often mentioned by analysts to describe the increased investor activity at the tail end of the previous year and at the start of the new one. Over the years several other reasons have contributed to the propagation of this belief. Just like with the Santa Claus rally, bonuses of Wall Street brokers invested immediately in stocks drive prices higher, as well as the “window propping” that portfolio managers do to make their investment funds look better.

January is also associated with a surge in activity by retail investors. This is explained by pure seasonality and the start of new investments, purely due to it being the beginning of the year. For instance individual investors might also make annual additions to their investment accounts – usually both of these involve the buying of stocks, not shorting them – giving more fuel to a potential climb in overall prices.

If we look at the statistics, the January effect is clearly visible from data as far back as 1927 – returns are at an excellent level of 3.9% for the Dow Jones. But if we take a closer look at the the period between 2000-13, then the lines get more blurred and we can see a drop of -1.55%. This might confirm that the phenomenon evens itself out and proves the existence of market efficiency, another interesting subject that will be among our future subjects.

Playing into the opinion that January is more random come the quarterly earnings reports at the end of the month (although they cross over in February), we can see surprises. These reports contain the financial statements of all public companies and reflect the last three months of the previous year. The holiday shopping season is usually a good gauge for this and provides a solid predictor for wider industry performances, but predicting how these earnings reports will pan out is a different game altogether.

In any case the January Effect, or rather the market performance in January, is seen as a major predictor for the whole year and it is indeed one of the most interesting months for traders. Perhaps lately too many people are aware of its importance and their actions are influenced by marginal factors and not the fundamentals, but as we know all too well, nothing is written in stone when it comes to the markets.

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