“Trying to change before you’re ready isn’t likely to be productive. For example, most New Year’s resolutions don’t last because people spring into action without being prepared for the work it’s going to take. Forcing change based on a date on the calendar, rather than a true readiness to transform, can be a setup for failure.” ― Amy Morin
“Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again. I’ve never forgotten that. I suppose I really manage to remember when and how it happened. The fact that I remember that way is my way of capitalizing experience.” ― Reminiscences of a Stock Operator, Edwin Lefèvre,
Please note, this will be the last weekly piece for the year. The next piece will be sent out between 6 and 8 January.
The beginning of a New Year seems like a great time to take stock of the last year and set goals for the next one. Unfortunately, by February an estimated four-fifths of people have failed to stick to the goals they have set for the year. Life-changing commitments are just hard to, well, commit to. The corollary of most people being unable to stick to their goals for more than six weeks, is that most of us are almost surely going about the process of setting goals the wrong way.
We do not know, or profess to understand, the reasons that most people fail to stick to their New Year’s resolutions or how to correct the process. It’s probably a combination of factors and life just getting in the way. That does not mean we cannot recognise the repetitive behaviour.
In this week’s piece we discuss the ‘January Effect’, a seemingly repetitive phenomenon occurring in capital markets.
The January Effect
The above is the average price return by month for the S&P 500 Index over a number of different time periods, all ending 30 November 2019. In all of the sample periods, the monthly return for the S&P 500, on average, has been higher in January than the average monthly return over the entirety of the respective period. In the two longest sample periods, January also has the highest average monthly return.
We do not have the same amount of data available for small-cap stocks, but at least for the 10 years, we can see that even in small cap stocks the average monthly return for January was well above the average monthly return for the entire period.
The January Effect is not limited merely to stock market outperformance in January relative to the other months of the year. Rather, it also extends to the type and form of stocks that tend to generate the highest returns during January.
Empirical research published in 2009, Gambling Preference and the New Year Effect of Assets with Lottery Features by Dorian-Jiang-Peterson, found evidence for seasonally high risk appetite at the beginning of the year. The research shows that lottery-type stocks – those with low prices, high volatility and / or high skewness – tend to outperform during January. Moreover, out-of-the-money options tend to be relatively more richly priced than at-the-money options – especially when compared to the relative pricing of the options in other months. The most striking relative outperformance in January was found to be that between high volatility and low volatility stocks.
Notably, the raised gambling appetite at the start of the year is not only an American phenomenon. In China, Chinese lottery-type stocks tend to outperform around the Chinese New Year (rather than in January).
Other empirical research has also identified the following phenomena related to the January Effect:
- Small-cap stock risk premia, that is the outperformance of small-cap stocks over large-cap stocks over the long-term, is almost entirely captured during Januaries. January is the time of year to be long small-cap stocks.
- High-volatility stocks, on average, only outperform in January and underperform the rest-of-the-year.
- Bond term premium – that is, the excess return from being long, longer-dated bonds over shorter-date bonds – is earned almost entirely outside Januaries. January is not the time of year fixed-income investors should be extending duration.
- Reversion-to-the-mean strategies tend to, on average, outperform momentum strategies in January. This is probably explained to some extent by tax-loss selling whereby underperforming stocks are sold at the end of the year to reduce tax liabilities and bought back at the start of year.
- High-yield debt and the US dollar, on average, tend to fare better in January than during the rest of the year.
Finally, some detailed but somewhat dated studies have found that the bulk of the January effect comes in the first few days of the year – a pattern also found in many other countries, even those where the tax year does not coincide with the calendar year.
Explaining the January Effect
The persistence of the January Effect is somewhat baffling; one would expect it to have been arbitraged away by now. The reasons often cited for its persistence are technical and behavioural such as tax-loss selling and institutional investor window-dressing.
Tax-loss selling puts general pressure on underperforming assets and those exhibiting low-levels of liquidity at year-end. A technical factor leading to the selling at year-end is also likely to contribute to inflated demand for such assets at the start of the year.
Institutional window dressing is the tendency of institutional investors to want to show safe, liquid and outperforming assets on their books when holdings are revealed at the end of the year. Such behaviour tends to drive demand for momentum stocks and government bonds in November and December, which is probably reversed at the start of the following year.
Another plausible behaviour factor is the feeling of starting the year anew and full of optimism. That is optimism is high in January and recedes over the course of the year as reality sets in and risks manifest.
Positioning
“Well, this is a bull market, you know” ― Reminiscences of a Stock Operator by Edwin Lefèvre
The longest bull market on record and probably the most hated is unlikely to go out on a whimper. We expect a few fireworks before its all over and that could make the coming January as exciting as any. For that reason, while we would keep some powder dry (cash on the sides), there is a case to be made to add some volatile names to one’s allocation.
That is why we added Slack Technologies $WORK and Uber Technologies $UBER to our Trade Ideas yesterday.
At the same time, we leave you with one more quote from Reminiscences of a Stock Operator, to remind you to reduce exposure once you are happy with your returns.
“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world.”
Thank you for your support during 2019!