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Posted on 18 March 2011 | 6,526 views

January Effect Stock Market Prediction

January is traditionally a good time to pick up bargains, in the stock market as well as anywhere else. The “January Effect” is that American stocks rise much more in January than in any other month of the year. Sidney Wachtel discovered the phenomenon in the 1940s, but it wasn’t until the 1970s that anybody took much notice.

The coining of the term January Effect is attributed to Donald Kiem. As a graduate student at the University of Chicago in the early 1980’s, Kiem discovered that stocks tended to increase in value during the first week of January. His study covered stock performance from 1963 to 1979. Recent market analysts have noted that this trend now appears to start near the end of December and carry over into the first few weeks of January. It has also been noted that the January Effect is more common among small cap stocks than larger cap stocks over $10 Billion.

The publicity of the January Effect has watered down the potential net gains from it over the past few years.

A down January is a bad omen for the stock market. Yale Hirsch of the The Stock Traders Almanac suggests that since 1950, every down January in the S&P500 preceded a new or extended bear market, or in some cases, a flat market. They go on to further suggest that down January’s are followed by substantial declines averaging -13%.

A rule that says “buy on Dec. 31 and sell on Jan. 31” just shouldn’t yield spectacular returns. Yet it has.

What is the January Effect?

The month of January in the stock market has strong significance in predicting the trend of the stock market for the rest of the calendar year. This phenomena occurs between the last trading day in December of the previous year and the fifth trading day of the new year in January. The January Effect is a result of tax-loss selling which causes investors to sell their losing positions at the end of December. The January Effect is predicated on the idea that these stocks, which have been sold off to realize the tax losses, will be at a discount to their market value. Bargain hunters step in and load up on these laggards and this creates buying pressure in the market.

Statistics from the first five Trading days in January

When the S&P500 has a net positive gain in the first five trading days of the year, there is about an 86% chance that the stock market will rise for the year, it has worked in 31 out of the last 36 years (as of 2006). The five exceptions to this rule were in 1966, 1973, 1990, 1994, and 2002. Four out of these five years were war related, while 1994 was a flat market. As history suggests, the markets average nearly 14% gains when the January Effect is triggered.

On the flip side of the coin, when the first five days of January are lower, there is no statistical bias of the market, up or down. It is anyone’s game at that point. Not a very reliable indication.

January Effect or December Effect?

In fact, history suggests that small cap stocks far outperform large caps during the middle of December. To avoid the sharp mark up in shares in the beginning of January, institutional traders have started accumulating many beaten down small cap stocks in December to get a head start on the January Effect. This shift has been seen in the markets and December has also become a very strong year for the stock markets, also known as the December Effect.

The champagne corks have been popped, friends have toasted to good health and resolutions for the New Year have been made. The streets have been swept clean of confetti just as many portfolios have been swept clean of stocks that yielded year-end tax losses. Yes, it’s that time again, when many investors will sell off stocks for tax losses to counter capital gains, then reinvest for the New Year. Every year this January strategy contributes to an increase in stock value, creating the market anomaly known as the January Effect.

What does this January Effect mean to you?

Although December and January seem to be good months for stock growth, the January Effect is a market anomaly, not a constant that is etched in stone. Not every small – mid cap stock will increase in value but, with some research and analysis, an investor may be able to take advantage of these January Effect stocks.

Here are some tips that can help you identify January Effect stocks:

1. It has been fairly well documented that this trend seems to affect smaller cap stocks more than mid-to-large cap stocks. An investor would want to search for stocks with a Market Capitalization between $200 Million and $2 Billion.

2. Identify the strong Small-Cap stocks. Search for stocks currently trading above their 20-day or 50-day moving average, stocks that have a good Earnings per Share ratio, stocks that have strong Broker Recommendations and stocks that have a strong average daily volume.

3. January Effect investors may attempt to bottom feed, looking for Small Cap stocks that are in decline or near their 52 week low after the December sell-off. These types of stocks can yield a high profit but if the fundamentals are too weak the investor may end up holding a stagnant or losing position.

Since there is no guarantee that all Small Cap stocks will rise in January, simply buying and holding potential January Effect Stocks could become costly and offer the investor little or no protection against a decline.

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One Comment »

  • Charlie said:

    In my country, it is a common practice to create a resolution every January. It can be a business resolution, love, life or whatever that is; then you work it out to fulfill it. As the saying goes, “plan your work and work your plan”.

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