Behavioural finance

The January Effect: Investor (Over) Confidence and the Making of Market Bubbles

Posted by MoneyController on 08.02.2021

2021 has officially kicked off and with it comes a predictable phenomenon: The January Effect. What is it, and is it helpful or harmful?

What is the January effect?

The “January Effect” is a seasonal buying/selling pattern that occurs every year. It begins in mid- to late December when investors dump their losses for tax breaks, pushing prices down. Low December prices, in turn, attract January buyers, which then drives stock prices up. Some analysts explain that the buying momentum builds from pressure on investors to pour money into their IRAs in order to meet annual contribution cutoffs - rational. Others claim it’s the result of widespread new year optimism - irrational. Some also claim it could be the result of buying patterns from institutional and official investors – rational and irrational. In any case, it’s likely a combination of all these factors. Given that, many see January as an ideal time to take up new investments: buy low, sell high OR buy high, sell even higher. Makes sense?

Is it real?

Different studies have confirmed the January Effect does exist. One study analysed data from 1904 to 1974. It found that the average return during January was five times higher than the average of all other months. The study also confirmed that the pattern is more noticeable among smaller companies. Likely because smaller companies tend to have cheaper share prices, making them more accessible to retail (amateur) investors. In another study carried out by Salomon Smith, he revealed that between 1979 and 2002, small-caps outperformed large-caps by an average of 82 points – but only in January. Some mutual fund and portfolio managers, however, say the January Effect has been diminishing over time. Goldman Sachs noted that returns have decreased in recent Januarys compared to figures from the 70s and the 80s. Perhaps the phenomenon is becoming too predicatable?

Is it happening now?

It seems the “January effect” is a thing in 2021. So far this year, the market is gearing up rather well. The S&P 500 is up 2.4% and small caps on the Russell 200 Index have shot up to 9.8%. What’s more, many of last year’s big losers are now staging impressive comebacks, namely oil and gas stocks. Occidental Petroleum is up 24%, Continental Resources has returned 17% and Gannett Co. has rebounded 25% compared to last year. 

So what’s behind all the January optimism this year? 

Among other factors, the primary driving force is that traders simply expect restaurants, coffee shops and food businesses to be reopened, theme parks and theaters to have less restrictions, and travelling to be allowed again in the coming 6-9 months. Investors believe pent-up demand will have consumers pouring money into these spaces. So there’s perceived opportunity in that regard. But is this rational or emotionally driven? 

The January Effect, while a real thing, is largely the biproduct of widespread speculative activity, emotional sentiment and herd mentality. The S&P 500 is now entering into bubble territory at today’s prices and the market is the most expensive it has been since the 1990s. Given that, current market plays are risky business. So be sure to practice sound judgment and seek out professional advice before you get sucked into price chasing.

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