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
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
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