We know that markets and the economy march to a different beat, but this has still been a surprisingly strong start to the year. The first five trading days of 2023 saw the S&P 500 rise by 1.4pc, the FTSE 100 by 3.7pc, Germany’s DAX by 6.2pc and Hong Kong’s Hang Seng by 8.1pc.
I have long thought that investors might look through the gloomy headlines in 2023 to better times ahead, but I didn’t expect it to happen just yet. The middle of the year, when it will hopefully be clearer that inflation is on the way down and the US Federal Reserve and other central banks are taking their foot off the interest rate brake, looked a safer bet. It’s a great illustration of why trying to time the market is a fool’s errand. No one rings a bell when the market turns.
It’s not so unusual for the market to rally at the start of the year. In fact, it happens sufficiently often for investors to have given it a name, the January Effect. This is not a new idea. The tendency for markets to perform well in the first month of the year was first identified decades ago and was popularised in the 1970s when a raft of academic papers attempted to get to the bottom of why this anomaly should exist.
Certainly, the data support the seasonality of markets. A long running study of the US showed that shares rose in January in 85 of the 130 years from 1890 to 2020. And, if anything, the effect has been more pronounced in some other markets. January has been a positive month more than 70pc of the time in the UK, Japan and Australia. In each case that’s a higher hit rate than in the other months of the year.
The percentage return in January is also higher in all four than the average for the other months. In Japan, the most extreme case, the average monthly return has been more than 2 percentage points greater in January than in the rest.
It’s easier to demonstrate that the January Effect happens than it is to explain why. There are a few explanations but none of them really holds water. The first is tax. The idea being that investors sell poorly performing investments in order to harvest a tax loss before the end of the year and then reinvest the proceeds in January, boosting returns. Plausible except that many mutual funds report capital gains in the year to October, not December, while private investors in the UK work to an April tax year end and to June in Australia.
Another common explanation is so-called window dressing, the tendency to clear out underperformers at the end of the year and replace them with more attractive stocks to spruce up portfolio lists at the end of a reporting period. This makes no more sense than tax because for every sale there’s a purchase of another stock. The net effect is potentially neutral. And anyway, passive funds, increasingly important, by definition don’t do this kind of tidying up.
The final suggestion - that January is simply the month when we resolve to do better, including getting to grips with our investments, might have more to it. But none of it really feels very persuasive.
A second January effect, the January Barometer, is bound to attract attention if the New Year rally continues. This one suggests that the way the market goes in the first month of the year is a harbinger of what’s to come in the rest of the year. A strong January is projected to lead to a strong February to December and vice versa.
The idea of the January Barometer was devised in 1972 by Yale Hirsch, founder of the Stock Trader’s Almanac. It’s arguably more interesting than the January Effect because, if there is anything to it, it offers the prospect of being a tradable signal in both directions. So, is there?
Supporters of the Barometer point out that since 1950 there have only been 11 occasions in which it has not worked in the US. That’s a hit rate of around 85pc, which in investment is about as good as it gets. The counter argument here is that this percentage is less impressive when you consider the general tendency of markets to trend up or down. It would not be surprising if in most years the direction of travel was the same in the first month as in the other eleven. Also, the Barometer may be self-reinforcing. A strong January in the market may encourage investors to invest, so shortening the odds of a strong rest of the year.
We have tracked this effect in the UK market for a few years now, using FTSE 100 data from the inauguration of that index in 1984. With 39 years in the bag, some trends can be seen. First, the adage has worked in 26 of the 39 years. A fall in January has led to a fall from February to December and a rise in January to a gain for the rest of the year.
However, there is a significant difference between the effectiveness of the Barometer in up and down years. There have been 18 years in which the market has fallen in January and in only seven of those did the market go on to fall in the rest of the year. So, a hit rate of under 40pc. In the 21 years in which the market rose in January, it has continued to rise in 16 and only fallen back five times. That’s a hit rate of nearly 80pc.
The problem with these kinds of seasonal adages is that they are not predictable and the trading costs of acting on them make them impractical. But eight in ten is compelling odds.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
