Investment markets are rich with the folklore of “can’t-lose” trading strategies that have minted fortunes for any investor who paid enough attention over the years.  Of course the logical response to any of this fanciful yore is: if it’s that easy to become a millionaire, why isn’t everyone a millionaire?  Still, some of these long-term “effects”, as they are generally known, do demonstrate some staying power.  In earlier posts we have talked about things like the “value effect” and the “small cap effect”.  I have refrained from gracing this blog site with anything at all about the “hemline effect”, the “Super Bowl effect”, or the “Presidential election effect” and can promise with near certainty that these somewhat more dubious notions will continue to not receive serious scrutiny by me in the year ahead.

But since it is after all the first month of the year I thought I would say something about the January effect.  This is a phenomenon that investors have been following with interest since a grad student at the University of Chicago named Donald Keim brought some of his research findings to light.  The thrust of the January effect is that (a) stocks tend to do better in January than in other months of the year; (b) much of the gains tend to happen in the first week of the year, and (c) small cap stocks benefit from the January effect more than large cap stocks.  There are several theories about why this seems to happen, the most plausible one probably being that investors tend to sell out of losing positions late in December to book tax losses, then come back into the market in January to reposition themselves.

So far performance in 2011 seems to suggest that another January effect might be on the way.  This past Monday was the first trading day of the New Year, and US stock indexes leapt up with gains over 1%, looking set to finish the first trading week on an up note (there is still one trading day left as I am writing this, though, so caveat emptor!).  But I am not so sure that I would ascribe strong performance this month to some perennial event that you can predict to happen.  Stocks indeed are on the rise, but in large part that is because there are continuing large outflows from the bond market (see last week’s post “Bonds in 2011”), and much of that money has a healthy appetite for risk, hence stocks would seem poised to benefit.

In general, and probably with the exception of the seemingly invincible value effect, I tend to argue against the usefulness of this “effect” folklore as a strategy for portfolio management.  There are two reasons for my thinking this way.  The first is that the factors which influence investment markets at any one particular time are for the most part local to that time.  As I suggested in the previous paragraph, this year stocks are off to a strong start because money has been coming out of the bond market at a steady clip since last October.  In fact December’s stock market performance, which saw the Dow jump from just over 11,000 to more than 11,500, may be a hard feat to replicate in January.  If investors were selling out of loads of positions for tax reasons in December in a time-honored ritual, that was certainly not the dominant trend.  The much more time-localized reaction to bond market weakness appeared to be a much stronger attribute for market performance.

The second component of my argument is just the old saw that there is no such thing as a free lunch.  If there were always a strategy for making outsize returns in the four-week period between mid-December and mid-January then I am fairly confident everybody would pile into it – and then it would cease to provide outsize returns.  This is the arbitrage argument: in a highly liquid and transparent market environment any “free lunch” is going to be exploited and the surplus profits will be arbitraged away.

It’s always worth factoring in conventional wisdom like the January effect into your investment research– if nothing else, it can offer a plausible explanation for certain aspects of investor behavior that can help refine your own strategy for approaching the market.  But January effects are not guaranteed, they certainly do not happen every year, and when they do it is often for other reasons.  Of course, if you increased your equities positions in late December anticipating the January effect…well, you certainly won’t be disappointed so far this year!

TAGS: portfolio management