The 'January Effect' Is More Market Myth Than Sound Analysis

Investors like to think of themselves as rational, calculating types. Most would laugh at the idea of forecasting the length of winter based on whether or not a rodent sees its shadow. And yet an eerily similar annual ritual grips Wall Street a month before Groundhog Day.Hotly dissected at the start of the year, of course, is the so-called "January effect." It's based on the notion that stocks get a boost at the start of the year as individuals and pension funds plow money into the market. The bang the year starts with, therefore, serves as a proxy for investor sentiment, and may be telltale indicator of stock market performance down the road.

%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% The Wall Street Journal, for example, notes that January was a weak month in both 2008 and 2009. That may have set the pace for the Dow Jones getting hammered in 2008 and led to major pain at the start of 2009. An Associated Press article, meanwhile, noted that the gains stocks made at the start of January in 2009 may have led to a saving rally through the end of the year despite the turmoil markets experienced early on. Despite the seeming contradiction, the basic point is the same: Investors should keep a close eye on January since it might have an outsize impact on the rest of the year's trading.

But despite the ubiquity of January effect analysis, and the temptation to trust the pattern, investors should be wary of this kind of prognosticating. It can serve as a convenient substitute for analyzing the state of the economy and other fundamentals like market valuations -- the kind of things that can provide actual insight into where things may be headed. And history is packed with examples where January's performance was highly misleading about things to come.

When It's Wrong, It's Very Wrong

January of 1929, for example, was off to a brisk start as the Dow Jones Industrial Average climbed to 317 from 307. But investors would be slammed later in the year by a historic stock market crash that heralded the start of the Great Depression. January of 1987, too, began nicely. The Dow climbed to 2160 at the end of the month after starting out at 1927. But Black Monday would hit investors in October of that year, leading to the sharpest historical stock market decline in percentage terms.

More recently, January 2001 had a strong showing when the Dow Jones finished the month at 10,887 after starting at 10,646. Those reading it as an auspicious beginning would be hit first by the further fallout from collapse of the dot-com bubble and then the massive decline following the September 11 terrorist attacks.

Of course, unexpected shocks led to the losses of 2001 more than the January start. But the same can be said for the lion's share of damage in 2008. While the Dow Jones Industrial Average may have dipped out the gate that year, it was the tanking of Lehman Brothers in the autumn -- an event that few foresaw -- that led to the real carnage.

Investors should have plenty of real research to keep them busy at the start of the new year. Industrial production in the U.S. and overseas seems to be robust. Unemployment data in January will be paramount and will weigh on the Fed's decisions about interest rates.

Data like that -- as opposed to how January starts -- will set the tone for the year ahead.
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