The January Effect and the January Barometer

by Andrew Horowitz

I hope you're getting your 2010 off to a great start and are steadily on your path to becoming a winning investor!

In this episode, we are going to talk about a popular investing belief about the month of January; many investors feel January can give us a clue about how the months ahead are going to unfold. 

In other words, some investors believe that January is a good barometer of how the stock market will perform throughout the rest of the year.

They sell their stocks and rotate into bonds because they believe that the market will fall for the year.

It may seem strange, but sometimes January does provide a good barometer, or measure, of what the rest of the year might hold.  I wouldn't rush out and sell everything just because one month is bad, nor would I buy stocks if January is a very good month, but let's pull back the curtain and learn a little bit more about the January Effect and the January Barometer.

The January Barometer

Let's first start with the January Barometer.  A barometer is a tool meteorologists use to measure atmospheric pressure.  Barometers can tell a little bit about the atmosphere and whether to expect storms ahead or clear skies. Thus, a barometer gives us clues about the future.

We define the January Barometer as the theory that the return of the S&P 500 in January sets the tone or stage for the direction of the stock market for the rest of the year.  So, if the S&P 500 was positive in January, then that would suggest that stocks would be higher by the end of the year.

What Happened the Past Few Januarys?

In January 2009, the stock market fell 6%.  But by the end of 2009, the stock market was up by double digits.

In January 2008, the S&P 500 also fell 6% in January and the market was... well 2008 was very bad.  The S&P 500 fell 40% in 2008.  Maybe the barometer does have value after all.

In January 2007, the S&P 500 rose just over 1% and ended the year up 4%.

In January 2006, the S&P 500 rose 2.5% and ended the year up 7%.

Ok, so there may be some grains of truth to the January Barometer, especially over the last few years, but it didn't work in 2009 and it doesn't work every single year.

How to Test the January Barometer

It's something that you can test out for yourself by looking at what the S&P 500 returned in January and then what happened by the end of the year.  It's more for fun than for making decisions as to whether or not to invest in stocks. 

If you followed the January Barometer's signals for a down year in 2009, you were on the sideline as the market rallied almost for the whole year!

The January Effect

The January Effect, on the other hand, does have some truth in stock market lore.

The January Effect is the tendency for small capitalization companies--mostly names of companies you probably haven't heard of--to outperform or do better than large capitalization stocks, which usually are names you have heard of.

The January Effect might be real because of how investors treat taxes.  Some funds or large investors might sell stocks in December to cut losses or record them to offset gains so that they can claim them on their taxes. Companies have to sell their stocks by December 31st to gain benefits for taxes to offset gains.

Then in January, companies sometimes buy these stocks back, or buy other stocks with the funds they raised from selling stocks. That causes stocks in general to rise in January.

However, small cap stocks, which are lower priced and usually more volatile than large cap, stable, blue-chip stocks move up and down more than stable stocks.
That means that small cap stocks often take the brunt of this selling tendency , which means their stock prices fall more. Then in January when funds buy these stocks again, their stock prices will rise quicker because they fell further.

That is the main explanation why small cap stocks, especially those that were beaten down in December, can outperform large cap stocks in January as investors put new money to work in the market by buying stocks across the board. 

Should You Believe the January Effect and Barometer?

So, while you probably shouldn't pay too much attention to the January Barometer, other than to find it something amusing to watch, you can potentially profit from paying attention to the January Effect and adding fundamentally strong small cap stocks to your portfolio that might have been sold in December. 

Don't buy a stock just because you think it is cheap, and always do your homework on the company, its ratios, its cash and liabilities situation, and other information. 

So, let's get our portfolio off to a great start in January and keep it going all through 2010!
One of the ways you can do this is by tuning in to my other podcasts. With those we discuss the details, give stock tips and learn a great deal from well known guests. Be sure to check out The Disciplined Investor Podcast and DH Unplugged--both available on itunes.

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com 

Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for making money in any market  wishing you all the best on your quest to investment success.