Posted by on Dec 15, 2015 in Articles & Advice, Blog, Featured |

Image Credit: “New York Stock Exchange, New Year Festivities,” ca. 1885-1890, Museum of American Finance 

By Jason Zweig | Dec. 15, 2015  9:23 p.m. ET

Every year around this time, investors and traders start chattering about the January effect, the pattern in which small stocks earn unusually high returns in the first month of the new year. Unfortunately, by the time people start watching for it, it’s typically almost played out already. Recent evidence suggests that the phenomenon persists, although it appears to be weakening and much of its impact is felt in November and December rather than January. Here’s a piece I wrote about the January effect long ago that still seems to hold up pretty well.

New Year’s Play

August 29, 2001: 4:44 p.m. ET

With Jack Frost nipping at our noses, it’s time to mull over the “January effect.” I’m not talking about snowstorms, eggnog hangovers or the spike in demand for refried beans over Super Bowl weekend.The January effect is simply the stock market’s habit of generating big returns on small stocks right after the turn of the year. Some analysts say you can mint money if you buy little stocks (or the funds that hold them) in late December, then bail out in the second half of January, after their prices surge.

The January effect is just one of countless beliefs that the calendar governs the financial markets. Many pundits claim that tech stocks always swoon in summer (inconveniently, they surged this August). Some say the market always drops in October (as it did this year). Others warn that stocks flop on Mondays. Friday is said to be a good day in the market, but you’re supposed to worry on Friday the 13th–when, say analysts, stocks usually go down. (However, Friday, Oct. 13, 2000 was one of the market’s best days all year.) Ralf Runde, a statistician at the University of Dortmund, has even found that German stocks tend to rise around the time of a new moon and fall when the moon is full. So far as I know, no one has yet studied whether this werewolf effect extends to the U.S. market.

Can you make money off any of this? As I wrote last month, the human brain is hardwired to perceive patterns even when they don’t exist. So investors need to examine all these ideas with scads of skepticism; what looks like a reliable pattern may turn out to be nothing but noise. What’s more, an investing approach that makes money in theory is useless unless it also makes money in practice, after you’ve paid the real-world freight of commissions, fees and taxes.

Yule be surprised

The January effect was widely publicized between 1976 and 1988, in scholarly articles and even a popular book, The Incredible January Effect by Robert Haugen and Josef Lakonishok. These studies showed that if you piled into small stocks (especially depressed value stocks) in the second half of December and held them into January, you’d beat the market by five to 10 percentage points. That amazed many academics, who typically believe that the market is too efficient to allow such oddities to persist. After all, if it were so easy to make money by buying cheap little stocks in December, surely everyone would do it and the opportunity would wither away. “There’s something funny goin’ on here,” says William Schwert, a finance professor at the University of Rochester. “If the profit opportunities are really this good, why isn’t somebody jumping in?”

So far, the January effect hasn’t disappeared. As the graph on page 90 shows, from 1926 through 1989, the smallest 10% of all stocks beat the rest of the market by an average of 9.4 percentage points in the month of January. The effect weakened slightly in the 1990s, but small stocks still outperformed by an annual average of 5.8 percentage points.

Unraveling the enigma

So why has the January effect persisted? First, many investors sell their crummiest stocks late in the year to lock in losses that will cut their tax bills. That selling pressure reaches a crescendo in December as the tax year nears an end. In January, the selling ceases, and these stocks often bounce back. Second, professional investors grow more cautious as the year comes to a close, seeking to preserve their outperformance (or minimize their underperformance). In buying a stock that may drop for the rest of December, fund managers run the risk of what they call “catching a falling knife.” And many managers shun battered stocks that will look bad in the year-end list of holdings they send to shareholders. As one portfolio manager tells me, “In December, guys just say, ‘I’m protecting my year.'”

Knowing that the January effect exists is one thing, but profiting from it is another matter. Large stocks–and the market as a whole–get no reliable boost as the year begins. Only the smallest 10% of stocks truly jump in January; outside the tiniest 20%, the January effect melts away. So forget about earning fat gains on giants like Cisco or GE by snapping them up in December and dumping them in January; nor can you count on high returns in most mutual funds at the turn of the year.

To cash in on the January effect, your best bet might be to buy a large basket of tiny stocks–not small caps, not microcaps, but nanocaps with a market value of less than $100 million. However, the Plexus Group, the leading authority on trading costs, estimates that buying and selling such itsy-bitsy stocks will cost you roughly 8% of your total investment. Thus, in the real world, your expenses will devour virtually all the gains the January effect produces in theory. (And, of course, the Internal Revenue Service will take up to 40% of any pennies of profit you have left over.)

Donald Keim, a Wharton finance professor who helped discover the January effect, is fatalistic: “It’s there, and it’s not going away, but you can’t use it. The trading costs are just too high.” Tobias Moskowitz, a University of Chicago finance professor, has co-written a paper showing how to profit from the January effect by buying small stocks and short-selling everything else. Yet he too sees trading costs as an insurmountable obstacle. When I asked him if he’s testing his theory with his own money, Moskowitz laughed: “Not interested,” he said. “Not me.”

Daydreams of riches

Another calendar quirk that’s received a lot of attention is the “weekend effect.” Historically, stocks have tended to go up on Fridays and down on Mondays. The inset graph above shows that from 1885 through 1989, stocks rose an average of 0.09% on Fridays and slipped 0.12% on Mondays. No one has fully explained why stocks should rise or fall more on one day than on another, though University of Arizona economist Edward Dyl offers one guess: Firms often release bad news on weekends, causing their stocks to slide.

In any case, as soon as researchers began writing extensively about daily stock returns, everything changed. In the 1990s, says Rochester’s Schwert, the average return on Mondays went from negative to positive; Fridays, which had averaged the week’s highest returns for a century, now dropped to third highest. So far this year, Thursday is winning, and Wednesday is in last place.

Schwert’s findings are easily explained by what I call Siegel’s Law. Laurence Siegel, who directs investment policy research at the Ford Foundation, has a saying: “Market inefficiencies tend to disappear right after researchers discover them.” Siegel’s Law tells us that if one day of the week truly earns higher returns, it won’t last long; investors will soon bid up prices until no excess profits are left.

In my view, Siegel’s Law applies to every calendar-based gimmick. So before you go dumping tech stocks every summer or buying in December, ask yourself some commonsense questions: Is there a logical explanation why this technique works? And if it does work, why isn’t everybody doing it?

The reality is that most calendar “patterns” aren’t patterns at all. For example, many investors believe that October is the worst month for stocks. But since 1831, says Schwert, October has actually averaged the fifth best return of any month of the year. The only indisputable pattern is that no month has trounced–or trailed–other months for more than a few years in a row. The leaders and laggards change constantly, without any warning.

The lessons of the calendar are clear: The right time to invest is when you have cash to spare. The right time to sell is when you need the money or want to adjust the riskiness of your portfolio. Any other attempts at timing are no better than superstition.