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.

Does the “Santa Claus rally” really exist for stock markets?

Does the Santa Claus rally really exist for stock markets

Does the Santa Claus rally really exist for stock markets

History suggests it’s real, most of the time

There are several things that inevitably find their way in stock market news come December. Annual performance, outperformers, stand-out companies are all mentioned and repeated ad nauseum. But one of the more curious ones is the so-called Santa Claus rally (it comes from the U.S. so no Father Christmas).

This curious description is used to describe the frequent rise in indexes and stocks, that comes at the end of the month, between Christmas and New Year. It’s one of the peculiarities of the market, as over longer periods of time many trends based solely on psychology and trader sentiment tend to even out. But statistics do show that it’s quite frequent (stats are for the U.S. index S&P, from 1930 to 2010, broken down per month and per week for December. You can easily fill them out to 2014 in the Trading 212 PRO platform).

Explanations for why this happens can be quite different. The most well-documented one is the anticipation of the January effect (we’ll get into more detail about it next week) – the practice of offloading stocks at the end of the year, so that no taxes are paid.. and then buying again into the market at the start of January.

Other reasons that fuel the rally are related to the traders and brokers that perform the trading itself. Bonuses on Wall Street are received before Christmas and are usually invested right away. Add that to the propping up of investment portfolios by fund managers, so that they look good at year end, and you have a strong foundation for an upturn.

Does the Santa Claus rally really exist for stock markets

The more unmeasurable explanation is that of increased optimism among traders. In a time for spending more time with family in sharing and giving (we know it doesn’t always happen like that, but let’s go along with it), some argue that it rubs off on market participants. This translates into a more bullish sentiment and actual stockholders prefer to keep it that way.

The phenomenon has also been observed in international stock markets, regardless of the popular religion of the country, or if they even have holidays at the end of December. Most analysts accept that U.S. indexes are the pacesetters most of the time and this pulls other countries upward.

There are still several things to remember about the rally:

  • It doesn’t happen every year and it can be quite small sometimes.

  • Some specific stocks can register serious losses while the wider markets are in the rally.

  • Indexes in different countries can perform differently due to economic and global events, and the last week of December isn’t devoid of geopolitical news and developments.

Still, the lone fact that this notion exists can be seen as an indicator of what market participants are expecting. Circumstances such as these can fuel a self-fulfilling prophecy, overriding fundamentals, news and technical indicators. In this case the power of the sentiment outweighs that of the usual predictors. It’s just like guessing what your Christmas stockings hold by weighing what’s inside.

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