January Effect

(Santa Claus Rally)

It's nearing the end of the year, summer is around the corner, cricket comes to fore and for the investor, the confidence that the market will continue to rise. Why the latter? The reason for the confidence is the December and January effect. Generally, it is thought that the share market always rallies over this period of time. However, is this really the case? Does the share market rally over this period of time or is this just a myth.

Since 1942

The January effect (also known as year-end effect or Santa Claus effect) is a calendar effect where the stock market, (especially small cap stocks) start rising from the last day of December until the fifth day of January. Economists call this an anomaly and it was first suggested in 1942. Over the past 20 or 30 year academics and scholars have written many articles, reports, books and research papers on this stock market anomaly. While the January effect refers to specifically the last day of December until the fifth day of January, the month of January has overall been a positive month for returns. This effect has puzzled many researches because there is no underlining fundamental reason for this to occur.

Some Theories

There are a number of theories as to why the January effect has occurred. Some people speculate that it may be related to the many year-end research reports on the small-cap market, which can make these stocks look like attractive places to put money. Another theory says that investors who need cash for the holiday season will sell some holdings; bargain hunters then swoop in to buy the sold-off shares. Others believe the effect may be related to tax-motivated selling and buying, ie, fund managers in the US might rush to buy back all those money-losing stocks they had previously sold to meet the tax-loss deadline.

This evidence contradicts the efficient market hypothesis (EMH), which suggests that all relevant information is already in the market, and therefore anomalies such as the January effect are not possible. However, the theory of efficient markets would imply that all technical systems would eventually become useless. In particular, as more investors become aware of the patterns, their trades might bring prices more into line with fundamental value, thereby eliminating the opportunity to profit from the pattern.

Getting in Early

In other words, if all investors are aware that share prices will move up in January then investors will anticipate this and start biding higher prices for shares in December thereby reducing the effect of prices rising in January. The actual effect of this will be that returns in December will become higher than returns in January. There is some evidence that this has already occurred since 2000. Arbitragers will in future years start biding prices higher and higher in earlier months and, in theory, eventually this will take out the December / January effect altogether.

The aforementioned theory might explain the December effect whereby stocks that have had a good year, that is, had their share price rising, will actually do better in the last few weeks of December, some say by an average of 2%.

Does this mean that prices will rise over the coming two months? The answer is, based on historical performance they probably will.

The Last Word

Others agree with another theory known as the Mark Twain effect, he stated:

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”