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.
Statistical response to an UP or DOWN January
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%.
January Effect or December effect?
The publicity of the January Effect has watered down the potential net gains from it over the past few years. 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.