It has long been claimed that markets are influenced by what is known as the ‘January Effect’ – the theory that share price performance in January, particularly in the first few days, sets the tone for the rest of the year.
While this has been challenged in recent years, it forms part of a wider group of theories that suggest that certain times of the year provide better, or worse, investment opportunities than others.
The January Effect has a long history. Research conducted by Rozeff and Kinney in 1976 found that from 1904 to 1974 the average monthly return in January was 3.5%. This compared to 0.5% for other months of the year.
The reasons for the disparity were largely anecdotal. The rise in share prices in the US was historically attributed to factors such as the effect of tax-loss harvesting in December (where investors sell losing investments to offset capital gains), people investing their work bonuses in January and fund managers buying stocks that had performed well in the year before, so their portfolios would look more attractive.
Another likely cause is the renewed sense of optimism in January. New Year resolutions may prompt individuals to invest for the future if they have not already started. Or to invest more. Researchers also noted that the so-called effect was more pronounced in an index of smaller-cap firms.
However, further analysis shows that the January Effect may have lost its appeal in the modern age. In fact, figures that chart the number of months that have produced positive returns from the end of 1986 to December 2017 reveal that January has been a middling laggard over this period, for both UK and US markets.
In a month by month analysis, December, October and April were the months that consistently produced the most frequent positive returns for the FTSE 100 index. January falls around the middle when it comes to average returns broken down to month by month. And, of course, disappointingly, the traditional ‘Santa Rally’ in stock markets didn’t happen last year. In fact, quite the opposite as December 2018 was one of the worst investment months since the financial crisis of 2008/9.
A related adage about the January Effect is that a good start bodes well for the rest of the year. Further analysis suggests that this is a flawed argument, as there are only marginal differences between the average returns following good and bad markets in January.
When there has been a positive return in January, the FTSE All-Share Index was also positive for the rest of the year,76.5% of the time. When January posted a negative return, the Index still delivered a positive result 71.4% of the time.
The January Effect is just one of a number of instances throughout the year loosely assembled under a banner called the ‘calendar effect’. This speculates that stock market returns can be seasonal, as during certain times of the year, whether a day or a month, markets are believed to do better or worse than others.
Again, much of this is anecdotal and thrives on investor psychology. Fears about October abound (because of Black Tuesday and Black Thursday in 1929, and Black Monday in 1987) but these worries are not backed up by data. October has posted 23 positive months since 1986, second only in the monthly rankings to December.
There are numerous other examples: the Santa Claus rally, the effects of St Leger’s Day (sell in May and go away), the September effect, the Monday effect (where Monday’s trends are said to continue from Friday’s) and so on.
While some are backed up by supporting statistics (for example investment returns in June and September have consistently been poor), to take advantage of these supposed effects requires the ability to time the market – knowing exactly when to dip in and out – to perfection. Notably, the weak markets of June and September are followed by much better average returns in July and October, highlighting the risks involved. Therefore, investors who try to time the market habitually lose out.
Looking for calendar effects in this way is an example of mistaking correlation for causation. It is a common pitfall for investors desperately hunting for any route to produce market-beating returns and end up linking events which really have no bearing on each other. There are plenty of examples that explore this folly in behavioral finance textbooks and beyond.
Various research concludes that trying to time the market will result in much less capital gains over time. A leading study in the US found that in the 30 years to the end of 2017, the average US “ do it yourself ” investor received a return of less than 4% a year, while the top performing investment funds delivered a return of more than 10% per annum.
By succumbing to the effects of overconfidence, pessimism and noise in the markets, investors who try to move opportunistically in and out of markets accepted less than half the returns associated with staying invested and the power of compounding.
It is always best to avoid knee-jerk reactions to events that briefly affect the market or those perceived to have the potential to do so. To meet long term investment goals, it is important to consider a strategic approach to portfolio construction and understand the damage that short-term measures can have on long-term portfolio value.
Calendar effects and trends come and go. As responsible stewards of our clients’ capital, Clarion Wealth ignore fashions and temporary peaks and troughs in the market and instead look to the lasting benefits of staying invested.
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