Investors around the world anticipate the month of January with excitement. This is because January tends to be, on average, a strong month for stocks, particularly those of smaller companies. However, the key word is "on average."
The stock market strength in January is not a foregone conclusion. In many years, the so called "January effect" does not happen, and in some of those times, the stock market experiences a pronounced negative return in January, as seems to be happening this year. January's stock market performance, in my opinion, depends a lot on how the year ahead is expected to unfold. Increased profit expectations from quarter to quarter and a steepening of the yield curve (the spread between the 10-year Treasuries and the one-year T-bills) – both of which are signs of healthy economic expectations – relate to positive January returns, while weakening of profit expectations and a flattening of the yield curve are associated with a negative January.
Let me explain.
The high average returns on risky securities in January are caused, in my opinion, by systematic shifts in the holdings of professional managers who rebalance their portfolios to affect performance-based remuneration. Institutional investors are net buyers of risky securities in January when they are motivated to include less-known, high-risk securities in their portfolios and are trying to outperform benchmarks.
Later on in the year, portfolio managers lock in returns by divesting from lesser-known, risky stocks and replace them with well-known and less risky stocks or risk-free securities, such as government bonds. Such behaviour affects prices and security returns in a predictable way. Risky stocks and high-risk bonds are bid up early on in the year and down later on in the year, whereas low-risk stocks and risk-free bonds exhibit the opposite behaviour – down early in the year and up later. On average, such behaviour causes the January effect.
However, my research shows that the strength in risky securities in January largely depends on what institutional investors think of the year ahead. A "January" seasonal is mainly observed when there are no recession or bear market expectations in January. This is normally the case when quarterly profits are increasing and the yield curve is becoming steeper. In recessions or bear markets, no January stock return seasonality is documented. In fact, when quarterly profits are declining and the yield curve is becoming flatter, a negative January effect is observed. This is because portfolio managers do not invest in risky securities indiscriminately, irrespective of whether the year is (or is expected to be) a bull or bear market and irrespective of whether the year is (or is expected to be) a recovery year or a recessionary year. Portfolio managers invest in risky securities when the year ahead is expected to be a good one and withhold their investment from such securities when the year ahead is forecast to be adverse.
I examined stock returns in January when the equally weighted index declined, as well as when this index rose in January, for the 1957-2012 period. The January return for the equally weighted index in a down market was, on average, minus 4.20 per cent. In an up market (i.e., when the equally weighted index went up), the average January return for the equally weighted index was, on average, 7.15 per cent. In other words, January returns, when they are positive, can be very strong – unfortunately, when they are negative, they can also be very negative.
The fourth quarter of earnings reports for the U.S. corporate sector are widely expected to show a "profit recession." In particular, S&P 500 profits are forecast to have dropped by 4.2 per cent in the fourth quarter of 2015, the second quarterly decline in a row.
At the same time, the spread between the 10-year Treasury bond yield and the one-year Treasury bill (the yield curve) has flattened from 2.08 percentage points in June of last year to 1.80 points in September and 1.59 as of the end of December.
Both of these statistics augur badly for the January effect this year.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos