01/08/2019 |
The January Effect and Other Seasonal Stock Market Patterns
Market technicians use statistics to identify patterns and predict future price movements. While technical indicators are the most popular example of these statistics, technical analysts also examine prices on a longer timeframe to try and identify seasonal stock market patterns.
In this article, we will look at three popular seasonal stock market patterns, examine whether they are still accurate predictors, and discuss how to use them to your advantage when trading.
The January Effect
Sydney Wachtel coined the term January Effect in his 1942 paper, “Certain Observations on Seasonal Movements in Stock Prices”, where he found that small-cap stocks outperformed the market in the month of January between 1925 and 1942.
More recent studies have confirmed the effect when averaging performance into the 2000s. In The Incredible January Effect, Haugen and Lakonishok found that the market performed much better in the month of January than any other month between 1927 and 2001.
There are several possible reasons for the effect:
- Tax Loss Harvesting: Many investors sell their losing stock positions in December to realize the losses and offset their tax bill for the year. The downward pressure in December leads to potential discounts in January.
- Portfolio Rebalancing: Many investors rebalance their portfolio at the end of the year to maintain their target asset allocations. The downward pressure on outperforming stocks in December could also lead to January discounts.
- Holiday Bonuses: Many people receive bonuses from their employers during the holiday season and may invest that capital into the stock market in January. The increase in buying pressure could boost stocks in January.
- New Year Resolutions: Some people may resolve to invest in the stock market starting in the new year, which could create buying pressure in January.
These trends are most pronounced in small-cap stocks since mid- and large-cap stocks are generally more liquid and efficient in adjusting for any temporary fluctuations.
Critics argue that the January Effect is becoming less pronounced over time as algorithmic trading leads to a more efficient market. The effect may become so small that the transactional costs needed to exploit it could make the strategy unprofitable for retail traders and investors.
Sell in May & Go Away
Old English stock brokers coined the phrase, “Sell in May and go away, do not return until St. Leger’s Day” more than a century ago. Since then, the adage has been shortened to “Sell in May and go away” or may be referred to as “The Halloween Indicator” given its October endpoint.
In 2012, University of Miami professors Sandro Andrade and Vidhi Chhaochharia found that stock returns were ten percent higher between November and April compared to the period between May and October. The study encompassed 37 different markets across a 14-year timeframe, meaning that the tendency to underperform in the summer may be a global phenomenon.
Bloomberg analysts found similar trends when analyzing monthly returns for the S&P 500 between 1988 and 2011:
The most common reason given for underperformance during the summer months is the lack of liquidity compared to winter months. Many traders and investors go on vacation in the summer, which limits buying (and selling). When they return, they may be more eager to deploy capital into the market.
Critics argue that studies on this effect use small sample sizes and small-time variations in expected stock market returns, which makes it an unreliable predictor of future stock market prices.
Santa Claus Rally
The Santa Claus Rally refers to the tendency of stock prices to increase between Christmas (December 25) and New Year’s Day (January 1). According to The Stock Traders Almanac, the effect yielded positive returns in 34 of 45 holiday seasons between 1969 and 2017.
There are several potential reasons for the effect:
- General Optimism: Most people are happier during the holiday period, which makes them more likely to take a bullish stance on the market. In addition, they may be eager to deploy their holiday bonuses in the market before they go back to work.
- Wall Street Vacations: Many institutional traders and investors go on vacation during the holiday period, which means that retail trading tends to dominate performance. Retail traders may be more bullish and less rational during this period.
Critics argue that the effect isn’t always consistent, and if a rally doesn’t occur, it could be the sign of a bear market.
Using the Effects
Long-term investors (such as retirement investors) don’t benefit very much from these effects because they are forced to pay short-term capital gains tax on any realized profits. The cost of these taxes and other transactional costs can offset a large part of the potential gains from moving in and out of the market.
On the other hand, short-term traders can benefit from these trends because they are already paying short-term taxes. Short-term traders often maintain a bullish bias during the Santa Claus Rally period and into the January Effect period, while taking a bearish bias during the summer months.
The Bottom Line
There’s little doubt that seasonal stock market patterns have existed throughout history, but past performance is no guarantee of future performance. The rise of algorithmic trading has made markets more efficient and many of these effects may already be priced into the market.
That said, short-term traders may want to use these seasonal stock market trends to help guide their trading by taking a bullish or bearish bias.
