January Effect

By now, you’ve heard that the US stock market is off to the worst start to a calendar year ever.  This is the sort of news that is trumpeted far and wide as humans are wired to value and pass along bad news (and to elevate the status of those who sound the alarm).  This undoubtedly helped our ancestors warn each other about saber-toothed tigers, but can trip us up as investors today, leaving us easy prey for today’s investment product-selling predators.  I even heard a local economics professor talking about the ‘January Effect’ on the radio this morning.  The ‘January Effect’ is the superstition that as January goes, so goes the rest of the year.  So if the month of January is positive, then so will the rest of the year.  If the month of January is down, the rest of the year will be negative, too.  It’s so easy and straightforward that someone should start a hedge fund and charge 2&20 to sit on cash for the rest of 2016.  So why isn’t the January Effect hedge fund a thing?  Why isn’t it the most successful investing strategy in history?  The January Effect is a way for brokers to get their clients to take action in their accounts, creating more commissions.  It gives pretty people something to read off of the teleprompter for a month every year. It gives us an explanation and forecast (albeit misguided) for something that behaves irrationally.

Let’s take a look at the numbers.  Going back to 1957, the January Effect works 74% of the time!  Holy Toledo, this thing works!!!  Time to get leveraged to the hilt and print some money!!!  Or it would be if there wasn’t a catch.  It turns out that there’s an April Effect, too.  The April Effect works just as well, 74% of the time.  The February, March, June, and November Effects all worked 65% of the time or better.  In fact, every month’s return for the past 58 years has predicted the next 12 months’ return better than a coin flip.

The magic behind the January Effect comes down to the fact that stocks generally move up over time.  Because January is often a positive month (to speculate why is an entirely different can of worms), it follows that the January Effect would be ‘right’ more often than months that are up less often.  While the calendar’s monthly returns are up 58% of the time, twelve month returns are positive 72% of the time.  Of the 24 times January has been negative since 1957, the calendar year was positive 50% of the time and negative 50% of the time.  So a negative month means it is more likely than usual for the next 11 months to follow suit, but that still doesn’t mean it’s written in stone.  In the end, statistics can torture the numbers to make them say anything.  It reminds me of a great scene from the movie ‘The Naked Gun’ where Leslie Nielson finds out that OJ Simpson’s character “has got a 50/50 chance at living… but there’s only a 10% chance of that.”

Photo by star5112