Stock Prices: January Effect on Stock Prices

Continuing further from the first part of this article on January Effect on Stock Prices, here is the second part:

A number of detailed explanations have been suggested for the observed January effect,
but few only the following give a reasonable justification:

• Tax loss selling by investors

Taxes are the biggest concern for traders and investors across the world.
In the US, December is end of tax-year. Hence, at the end of the tax-year, there is wide spread selling of the stocks which have 'lost money' to capture the capital gain, driving down the prices, presumably below true value, in December, and a buying back of the same stocks in January, resulting in the high returns.

Then, there is also a “wash sales rules” which prevents an investor from selling and buying back the same stock within 45 days, and there has to be some substitution among the stocks.
Thus investor X sells stock A and investor Y sells stock B, but when it comes time to buy back the stock, investor X buys stock B and investor Y buys stock A.

It will be interesting to note the same effect happening in the month of March to April for countries like India, where the financial year ends in the month of March. Moreover, there is no such rule like “Wash Sales Rule” in India, so traders can keep on betting on the same stocks again and again.

• A second reasoning is that the January effect is related to institutional trading behavior around the turn of the years. It has been noted, for example, that ratio of buys to sells for institutions drops significantly below average in the days before the turn of the year and picks to above average in the months that follow. However, once again to repeat, it has only been observed historically. There is no guarantee that the same will continue further.

• A third and very important Behavioural Aspect that has been observed is due to Christmas and Holiday Season. Since it is festival and holiday time in the US (and other western countries), people need money for spending – either for buying gifts for their loved ones, making new purchases for self and family, or for going on enjoying the holidays. All this results in huge spending and the investors usually try to take the money out of their investments. Hence there is wide spread selling. This again causes stock prices to tumble just before festive season, i.e. early and mid-December. The same investors will again come back in January for putting in fresh money and starting again, hence the January effect predominates.

Not only for USA, the January effect is prominent for other countries as well. Here is the graph showing the historical returns in the month of January as compared to other months for different countries across the globe.



However, all the observation and data dates back to 1927 and is primarily concerned with USA stock markets. It forms an interesting case for other countries like India because firstly, the Indian financial year is different from the US financial year and secondly, the festive season is in October-November (Diwali/Dusshera). So things may be different for stock markets like India.

However, the Indian stock markets are still dominated by FII and other foreign investments, so this effect can be seen in India too. We are about to enter January, so one may try his luck if he or she wishes - off course at his own risk ! :-)

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Seasonal Effects on Stock Prices:January Effect

Here is something that might be of great interest to the traders and market-makers who trade on intra-day or weekly basis:

Empirical studies suggest that a variety of seasonal and temporary effects can be observed in the behaviour and movement of stock prices. Among them, the primary ones are:

• The January Effect: Stocks, on average, tend to do much better in January than in any other month of the year.

• The Weekend Effect: Stocks, on average, seem to do much worse on Mondays than on any other day of the week.

• The Mid-day Swoon: Stocks, on average, tend to do much worse in the middle of the trading day than at the beginning and end of the day.

One thing should be noted very well that while these empirical effects are only historical, they atleast provide some basis for traders, However, it is not at all certain whether any of them can be used with 100% accuracy to generate excess profit from stock trading.

In this article, I’ll concentrate only on the January effect and in the later articles, I’ll cover the remaining.

The January Effect in Stock Prices

• Studies of returns in the United States and other major financial stock markets have revealed strong signals in return behavior during different months of the year.
• As observed, Returns in January are significantly higher than returns in any other month of the year. This phenomenon is called the year-end or January effect and it can be traced to the first two weeks in January.

Another interesting observation is that the January effect is found to be much more prominent for small cap stocks or small firms than for larger firms.

As can be observed from the graph of the figure above, the monthly returns in the month of January have been significantly higher. However, the data used dates back to 1927 and hence conclusion can be drawn from the above chart for trading only based upon your risk taking responsibility.

In the next article, let's discuss about the explanations, reasoning and whether and how to benefit from such an effect.

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