That most common explanation doesn’t specifically apply to small caps, but also is geared toward the market’s weaker performers in the prior year (which in many ways have become de facto “small caps”). It simply suggests that investors sell off their biggest losers before the end of the calendar year for tax write-off purposes, then buy them back in the beginning of the year. Fund managers have been accused of doing the same so they don’t have to show a losing holding in their end-of-quarter reports.
There’s a less-favored explanation, too: Since annual bonuses tend to be paid in January, that inflow of extra cash is put into the market over the course of the month, boosting stocks. But again, it’s not a strongly supported idea.
‘As Goes January, So Goes the Year’
Since 1945, a bullish January preceded a bullish rest of the year more than 80% of the time — odds anyone would gladly take to Las Vegas. It gets even better on the bearish side of the table, though. Jeff Hirsch — publisher of the highly recommended Stock Trader’s Almanac — has concluded that every losing January since 1950 did indeed mark a flat-to-bearish year. Not bad.
The most common explanation is the obvious one: If traders are optimistic about the whole year, they’re likely to take positions as soon as possible. If they’re feeling pessimistic about it and were just looking to delay tax-based selling until the new year, that also will be reflected early on in the year.
And what about the “first five days” deal? That assumption doesn’t hold enough water to act upon.
History has shown that if the first five days of January are bullish, a little more than two-thirds of the time, that whole year will be a winner. Impressed? Don’t be. History also shows that if the first five days of January are bearish, the market moves higher that year about two-thirds of the time anyway. In other words, the predictive power of the “first five days” premise isn’t much better than a coin toss. The logic of it sure sounds good, though.
As you can see, sometimes the assumptions are backed up by numbers, and sometimes they’re not. The data does generally support these January Effect theories. As such, they are worth following … cautiously. Two caveats are rarely discussed, however.
- When the theories don’t work, they really don’t work — in a massively painful way. In other words, traders usually can’t afford to be on the “exception” side of the table, rare as they might be.
- While the correlation between January’s performance and the rest of the year is high, that same statistical correlation applies to February’s performance, March’s performance and so on. If we’re in a bull market, we tend to see bullishness in most months, creating an overall bullish year. The same goes for bear markets. So don’t draw too much of a cause-effect conclusion. It’s a correlation, albeit a powerful one.
Regardless, nothing replaces old-fashioned common sense and just paying attention to the market.