With January around the corner, many investors are getting itchy fingers. This is because January tends, on average, to be a strong month for stocks, particularly those of smaller companies.
But is this so-called January Effect a forgone conclusion? To answer this, it's vital to look at what drives the typical strength in stock prices at the start of the year. In my opinion, the biggest factor is the behaviour of portfolio managers.
Institutional investors are net buyers of risky securities in the early months of the year when they are most focused on outperforming the market or benchmarks.
As the year draws to a close, portfolio managers sell lesser-known, risky or poorly performing stocks. They replace them with well-known and less risky stocks or even risk-free securities, such as government bonds. This shift to safety is motivated by the desire to lock in returns and "window dress" the portfolios that portfolio managers will show clients in annual reports.
The excess demand for risky securities early in the year bids up the prices of these securities and drives down the demand for lower risk securities. The opposite happens towards the last few months of the year.
You can see these tendencies quite clearly by comparing the January returns for an equally weighted portfolio of stocks vs. a value-weighted portfolio. An equally weighted portfolio holds all stocks in equal proportions regardless of their size, so it is tilted toward smaller stocks. On the other hand, a value-weighted portfolio tends to emphasize large cap stocks. (Note that most standard market indices hold stocks in proportion to their market capitalizations, so the biggest stocks account for the biggest part of the index.)
For the period 1957-2007, the average January return for an equally weighted portfolio of stocks – the one that is weighted toward small cap stocks – was 5.30 per cent. The corresponding return for the value-weighted portfolio (the one tilted toward large cap stocks) was 2.20 per cent. The return for government bonds was not statistically different from zero.
Smaller cap stocks show strength at the beginning of the year, with the rest of the year, especially the second half of the year, showing widespread weakness in relation to January. The opposite is true for larger cap stocks and government of Canada bonds.
However, I find that the strength in risky securities at the beginning of the year is not a sure thing. It largely depends on what institutional investors think of the year ahead. The January effect is largest when there is no recession and when money managers don't believe there will be a bear market in the year ahead.
The January effect is considerably weakened when the economy is feeble. For example, in recessions, the value-weighted index had a January average return of minus 0.30 per cent, while the equally weighed index had a 3.50-per-cent return and the government bond index a 1 per cent return.
Portfolio managers, in general, invest in risky securities when the year ahead is expected to be a good one and, mostly, withhold their investment from such securities if the year ahead is forecast to be adverse.
I also examined stock returns in January compared to the rest of the year in years when the equally weighted index declined, as well as when this index rose in January for the 1957-2007 period.
The January return for the equally weighted index in a down market was minus 3.42 per cent. For the rest of the year, the mean monthly return was not statistically different from zero. It seems when the market goes down in January, the rest of the year goes nowhere and if one includes the strong negative January returns in the calculation, the whole year is a down year.
In years when the equally weighted index rose in January, the average return for the month for the equally weighted index was 7.67 per cent vs. an average monthly return of 1.39 per cent for the rest of the year. In other words, strong January returns beget positive returns for rest of the year for the equally weighted index. This supports an old investing adage: "As January goes, so goes the year."
There are two lessons from the above discussion. First, this January's stock market performance may not be a slam dunk. It all depends on how institutional investors expect 2014 to unfold. Second, January returns, when they are positive, they can be very strong. Unfortunately, when they are negative, they can be very negative.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos