Bogus Effect

images 2This time of year, we often find ourselves reading about the “January Effect,” which is sometimes described as a predictable way to forecast returns, and sometimes as a way to know whether this is, or is not, a good year to invest and make some money.

Unfortunately, most of this reporting is nonsense.Let’s start with the predictable part. Wouldn’t it be nice if, even for just one month of the year, we could know whether the market is going to go up or down? That’s what market pundits are implying in their January Effect reporting: that markets have a strong tendency to rise in January. Why? The explanation, first offered in 1942, is twofold:

1) Stock investors tend to harvest their tax losses at the very end of the year, selling any stocks that happen to be below the price they paid for them, and, of course, claiming the loss on their tax returns. This selling activity depresses the prices of stocks generally in late December (Why do we not hear about a
negative “December Effect?”), but when those investors buy back into the market in January, the additional buying demand pushes up prices.

2) Mutual funds, who are the biggest stock investors, have to report their holdings as of the end of the year. If they made an embarrassing mistake and purchased a stock which subsequently dropped like a stone, the portfolio manager engages in an exercise known as “window dressing:” she conveniently sells that stock
right before December 31, and then reports a portfolio that doesn’t include the losing investment. This is a great way to prevent reporters from asking pointed questions about what they might have seen in that dog stock when they purchased
it in the first place. And it makes it look like, despite what might have been poor performance throughout the year, the fund is strangely only invested in stocks that went up.

Of course, the cash position is only temporary; the fund will put the money to use in January. Just like the tax harvesting activity, these sales in December and purchases in January, we are told, have a wind-at-the-back impact on share prices in the first month of the year.

So why is this nonsense? Back in 1942, and for some years afterwards, it might have made sense to do all your tax loss harvesting once a year as the holiday decorations were being taken down at the malls. Today, with modern software tools, professional investors can check daily to see if there are portfolio losses they can harvest, so the buying and selling is spread out through the year. Also, today’s mutual funds report the contents of their portfolios quarterly, rather than annually, so the window dressing activity (which still goes on), happens each fiscal quarter,
rather than all at once at the end of the year.

Moreover, a quick glance at history suggests that returns in the month of January have been pretty random for this century’s investors. The S&P 500, in the calendar month of January since January 2000, has delivered returns of -4.18%, +6.45%,
-2.12%, -5.87%, +2.04%, -1.73%, +0.89%, +1.53%, -4.74%, -11.37%, -5.22%, +1.12%, +2.77%, +2.44% and -0.77% last January. If you can see a pattern there worth betting on, chances are you’re also a genius at the racetrack.

The other January Effect says that if stocks rise in January, they will be up for the year, and if they fall in January, then the market will deliver losses through December. Of course, any time you give the market a head start in either direction, there will be a slight tendency for the rest of the year to follow suit–similar to if
you saw an Olympic sprinter break out of the blocks ahead or behind the pack, you would notice a tendency to finish ahead or behind. Not a guarantee, you understand, but a tendency.
Looking at the historical record, when stocks finish the first month down, they finish the year down 58% of the time–almost exactly what you would expect within the statistical probabilities of randomness. Researchers have actually determined that–probably also due to random factors–the returns in September
have historically been the best predictor of returns for the year as a whole.
The truth is, none of us have a way to predict even a week, much less a month, much less a year of market returns. Whenever we read about the Super Bowl winner predicting the market, or the month of January or September or the winning party in the Presidential election, we should recognize that the article is being
written purely for entertainment, giving us a chance to fantasize that, somehow, we can, for a moment, know the unknowable future and maybe even profit from it.
Sources:
http://moneymorning.com/2013/12/26/january-effect-exist/

http://blogs.wsj.com/moneybeat/2014/01/15/so-much-for-the-january-effect-sp-500-back-in-record-territory/

http://blogs.barrons.com/stockstowatchtoday/2014/01/14/after-the-drop-as-january-goes-so-goes-the-year/

http://www.businessweek.com/articles/2014-01-07/investors-looking-for-a-january-effect-should-wait-a-few-months

About Objectively Speaking

Tom Batterman, founder of Vigil Trust & Financial Advocacy and Financial Fiduciaries, LLC is in the business of representing the best financial interests of his clients. Having provided objective, fee-only financial management services for over two decades, he specializes in managing the investment and related financial affairs of individuals and mutual insurance companies who do not have the time, interest or expertise to manage such matters on their own. As an objective, unbiased professional who takes on a fiduciary responsibility to his clients, he guides clients to the financial decisions they would make themselves if they had years of training and experience and the time and expertise to fully research and understand all of their options. Founded in 2010 as an outgrowth of Vigil Trust & Financial Advocacy, Financial Fiduciaries, LLC is a financial management solution for individuals and mutual insurance companies who recognize they do not have the time, interest or expertise to properly attend to their financial matters on their own. While there are many financial “advisors”, most of them have investment products to sell and the “advice” they provide is geared toward getting their clients to engage in a purchase. As one of the rare subset of advisors known as “fiduciary advisors”, Financial Fiduciaries does not sell any investment product so its guidance is not compromised by conflicts of interest which plague ordinary advisors. Prior to his employment in the financial industry in financial advocacy and trust positions, he worked at a private law practice in the Wausau area in the areas of estate planning, tax, retirement planning, corporate organizations and real estate. He is a graduate of the University of Wisconsin-Madison and the UW-Madison Law School and has during his career held Series 7, 24 and 65 securities licenses. A longtime resident of the Wausau, Wisconsin Area, Tom is active in the community. He enjoys golf, curling, skiing, fishing, traveling and spending time with his family.
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