The January Effect

"As goes January, so goes the year." - Stock market saying

When trading stocks there are a few signals that cannot be explained by efficient market hypotheses.  One of these signals is the January Effect.  This so called "effect" is an unusual indicator given by the returns of the small cap market in the month of January each year.  If one believes in the Random Walk Theory popularized by Burton Malkiel, that is that stocks do not follow patterns but act more like a person walking in random directions, then January should not be an important month.  However studies have shown that from 1904 to 1974 that the average January return for these stocks was roughly 3.5% whereas the average monthly return for each month outside of January was only 0.5%. 

This can be taken one step further as the saying in the quote above so taking this quote literally I went back to look at the last twenty years of data for both the Russell 2000 Index (small cap stocks) and the S&P 500 (large cap stocks). 

For the Russell there were six years when the market was down in January.  Of these six years only three or 50% resulted in a down year and the rest produced some significant returns (see data below). 

2002   Jan (1.82%)   Year (20.56%)

2003   Jan (4.17%)   Year 42.50%

2008   Jan (9.88%)   Year (39.60%)

2009   Jan (2.77%)   Year 35.83%

2010   Jan (4.92%)   Year 24.81%

2011   Jan (1.88%)   Year (6.97%)

Looking at the S&P 500 produced similar results with six negative returns in January but only two corresponding down years.  So the S&P 500 was only down 33% of the time following a down January (see data below).

2002   Jan (1.42%)   Year (22.60%)

2003   Jan (3.50%)   Year 23.60%

2005   Jan (3.20%)   Year 3.56%

2008   Jan (8.10%)   Year (40.99%)

2009   Jan (2.92%)   Year 29.29%

2010   Jan (4.59%)   Year 11.90%

Looking at the magnitude of the downward movements in January does not show much other than when the move was significant or more than 5%, it set the stage for a very poor year.  Outside of that it appears to be a coin toss as to how the rest of the year will progress however, the data did show that over the last 20 years, there has not been a 20% plus down year without a negative January.  It also pointed to a very directional year in that the magnitude of the moves following a down January were all double digit returns (either positive or negative) barring one year for the S&P 500.  Furthermore each massive downward swing came on the back of significant run ups in the previous five years (anybody remember 2002 and 2008?) and all of these meltdowns began with a poor January.

So while this poor January may not be a harbinger of a poor year ahead especially since the market is down less than 5% for the month (at the time of this writing), it is certainly an indicator that you should keep in the back of your mind as all poor years begin with a poor January and expect a rollercoaster ride for the remainder of 2014.