Investors around the world anticipate the month of January with excitement. This is because it tends to be, on average, a strong month for stocks, particularly those of smaller companies. However, the key phrase is “on average." In many years, what is known as the “January effect” does not happen.
January’s stock market performance 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 yields on the U.S. Treasury’s 10-year and one-year notes) – both of which are signs of healthy economic expectations – relate to positive January returns. 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 portfolio 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 lesser-known, higher-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, riskier stocks and replacing them with well-known and less risky stocks or risk-free securities, such as government bonds. Such behaviour influences 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 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. January stock-return seasonality is mainly observed when there are no recession or bear market expectations in the month. This is normally the case when quarterly profits are increasing and the yield curve is becoming steeper. In recessions or bear markets, no seasonality is documented. In fact, when quarterly profits are weakening 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.
There has been a lot negative economic news recently, with some analysts forecasting a significant economic slowdown and even a recession in the near future, a forecast driven by the U.S.-China and U.S.-European Union trade wars. Trade wars among powerful countries such as these are a recipe for economic growth destruction. History has provided us with a lot of insight in that respect. Moreover, when you add the potential of slowing economic growth to rising interest rates, the issue of global debt comes into play. Global debt at both the consumer and government level has been on the rise for years, reaching a record high in 2017 (the last year for which data are available). This was not a problem when economies hummed along and interest rates were at rock bottom. But with economies slowing down and interest rates rising, these excessive debt levels start to become a serious issue. In light of all this, the U.S. corporate sector is widely expected to experience weakening earnings, possibly a “profit recession," as profit margins are squeezed by rising costs and reduced economic growth.
To add insult to injury, the spread between the 10-year and one-year Treasury yields – the yield curve – has flattened from 59.3 basis points at the end of June to 18.9 basis points as at Dec. 18. Moreover, earlier this month, on Dec. 3, part of the U.S. yield curve inverted, with the five-year note yield dipping below the two-year note.
These statistics augur badly for the January effect, and I am sure they will be in the minds of portfolio managers when they make their asset allocations this January. Now, on a more positive note, if we are lucky and trade wars are favourably resolved soon, then we may be able to see a strong relief rally in stock prices early on in 2019.
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