The January Effect and Christmas Turkey
At The Private Office, we stay abreast of financial academic research both current and going back to the early days of the share markets. One of the first topics in financial research was the study of seasonal trends in share prices. You may have heard of the "January effect”. As we have just observed another January data point, we thought this would be an opportune time to have a dive into at the academic literature on the January effect to see whether it would be wise to incorporate this in our investment process.
The first study about the January effect was conducted by Sidney Wachtel in the 1940’s. He published a paper in the Journal of Business, "Certain Observations on Seasonal Movements in Stock Prices”.
Wachtel observed what appeared to be a consistent seasonal pattern in share market returns. According to his observations, share markets rallied each January. In fact, January often had the best returns of any month of the year.
What’s more, after looking at results from subsequent years, the pattern seemed to hold up. It was such a phenomenon at the time that people started grasping for answers as to why this was happening. Suggestions abounded. With the US tax year ending in December, was it money going back into the market from investors who sold in December for tax purposes? Others suggested it was due to underlying emotional or psychological reasons, such as a New Year’s resolution to invest in the share market and an influx of money was invested in January as a result. Economic professors even conducted lab experiments to determine if they could replicate the issue in simulated markets operated by students.1
Things went from strange to bizarre. As investors became aware of the January effect, they started anticipating it. They would buy up at the end of the year, thinking they could get in ahead of the crowd. This became known as “The Santa Claus Rally”.
However, since 1980 clear evidence of a January effect is difficult to find as the chart below from Schroders and Refinitiv highlights.
To understand if this was a universal phenomenon, Mahendra Raj and David Thurston studied the topic in a New Zealand context. In an article, “January or April? Tests of the turn–of–the–year effect in the New Zealand stock market”, published in Applied Economics Letters, the authors postulated that if the January effect was due to taxes, it should show up in New Zealand in line with the new financial year starting on 1 April. What is unclear is whether Raj and Thurston considered that New Zealand’s lack of a capital gains tax makes locking in a tax loss at the end of a financial year, a bit of a non-issue.
However, their conclusion was, “The study finds that there is neither a January effect nor an April effect in New Zealand.”
Another paper, published in 2010, pointed out that the worst returns in New Zealand are typically in August.
The authors’ assessment was “probably due to the fact that August is the bitterest and rainiest month of the year in New Zealand.”2 In other words, they had no idea why. More pertinently, the authors concluded there were “no typical seasonal anomalies” in January or April in New Zealand.
If you believed in the January effect and positioned your portfolio for a rally last month, you would have been disappointed. In line with global market declines, our local NZX 50 Index fell almost 9%. It’s understandable that people are looking at this negative performance. But if there was such a thing as the January effect that predicted positive monthly returns, then 2022 was clearly a year that broke the pattern. Perhaps because there never was a pattern, no matter how the data over discreet historic time periods may have looked.
So why did markets decline last month? There are a few reasons, but the most important is that central banks, especially the United States Federal Reserve, have suggested that in response to inflation, they will be increasing interest rates this year. This makes borrowing more expensive, which makes money-making ventures based on borrowing less profitable overall. Everyone understands that, and those Kiwis whose mortgages come up for renewal in 2022 will really understand it.
Financial writer, Ben Carlson3, recently shared in his blog that most years in the United States (59 out of 94 to be precise) there was some point during the year where markets lost 10%.
That’s worth emphasising. In most years, markets are down by 10% at some point in the year. Carlson also found that in most years, markets finished positive.
So, what can we learn from one month’s worth of data? We’d suggest not a lot. Unlike the pattern seekers that coined the January effect or the Santa Claus Rally, our advice is consistent and built for the long term. Our plans are resilient to fluctuations whatever month they arrive in. Clients with a short-term need for spending should have defensive assets in their portfolio. For those with long-term spending needs, one month’s performance is not something to be distracted by.
Academics have produced hundreds of papers over the years trying to find repeatable patterns in share markets, looking for opportunities to systematically outperform the markets. The January effect is just one of those rejected hypotheses.
At The Private Office we advocate an evidence-based investment approach, however, we only implement strategies that are academically proven to be robust, persistent, prevalent, sensible and cost-effective. The most recognised anomalies that have earned academics Nobel Prizes are the size, relative price, and profitability premia in equity markets. These are the anomalies we pursue for clients to enhance returns over the long term.
Unlike in the United States, January is our month for family, sun, and holidays. We are not relying on share markets to deliver the Christmas Turkey each year.
1. Anderson, Lisa, Gerlach, Jeffrey and DiTraglia, Francis, (2005), Yes, Wall Street, There Is a January Effect! Evidence from Laboratory Auctions, No 15, Working Papers, Department of Economics, College of William and Mary.