LONDON (Reuters) - Sharp falls in equity markets over the first days of 2008 may be robbing some investors of their best chances of gains this year and setting the stage for a grim 12 months ahead.
A man looks at stock market monitors in Taipei January 7, 2008. REUTERS/Nicky Loh (TAIWAN)
It is January and according to financial market folklore -- or “streetlore” as it has been called -- what happens this month is both a predictor of things to come and, for some, as good as it is going to get.
Under this scenario, the early losses in stock markets battered by slowing economies, credit bottlenecks and soaring oil prices are doubly bad news.
“The recent action on Wall Street and on global markets is very negative because you would expect positive returns at this time of year,” said Mark Hirschey, a University of Kansas professor who has studied the so-called January Effect.
U.S., European and Japanese stock markets fell heavily over their first trading days of the year, although there was some recovery in Europe on Monday.
Overall, MSCI's benchmark gauge of world stock performance .MIWD00000PUS has lost more than 3 percent so far in 2008 compared with a gain of 9.64 percent for the whole of 2007.
The January Effect is one of those anomalies in financial markets -- like U.S. presidential years, selling in May, and the odd sporting event result -- that purport to influence markets despite seemingly having little to do with fundamentals.
There are actually two effects. One is that January stock market returns have a predictive power for returns over the next 11 months. The second is that for small capitalisation stocks, in particular, January is the best month of the year, with most of gains coming in the first few days of trading.
Particularly bad news for some, then, that the Russell 2000 .RUT, the benchmark for U.S. small caps, lost 5.8 percent over the first three trading days of this year.
HISTORY AS GUIDE
Furthermore, there is evidence that the January Effect is more than just investor mythology.
Michael Cooper, John McConnell and and Alexei Ovtchinnikov, researchers from the University of Utah, Purdue University and Virginia Polytechnic Institute, looked at January returns from 1940 to 2003 and found them “surprisingly robust” predictors.
“January returns have predictive power for market returns over the next 11 months,” they said in a paper published in November 2006 in the Journal of Financial Economics.
They found that the effect persisted after allowing for macroeconomic and business cycle variables and shifts in investor sentiment, among other things.
Specifically, the research found that on average if stocks had a positive January, they returned on average about 14 percent over the next 11 months. If January was negative, they lost nearly 4 percent during the rest of the year.
Kansas University’s Hirschey and colleague Mark Haug, meawnhile, looked at what they described as the abnormally high rates of returns on small cap stocks in January.
Their research followed on from a 1976 study that tracked New York Stock Exchange returns from 1904-1974 and which showed an average January gain of 3.48 percent compared with average gains of just 0.42 percent a month in the remaining 11 months.
Most of the effect was due to small caps, a trend that was confirmed by the Kansas researchers.
Hirschey and Haug revisited the 1976 study in the Financial Analysts Journal of September/October 2006, looking at different types of returns between 1802-2004 and 1927-2004.
“We can say with some confidence that there really is (an effect),” Hirschey told Reuters. “On average, the first few trading days of the year is a wonderful period for returns on small cap, beaten down stocks.”
Hirschey also said that although studies have focused on U.S. equities, the January Effect is global. “It is a worldwide phenomenon,” he said.
WINDOW DRESSING
Various reasons are given for the effect, including tax treatments that encourages investors to sell losing stocks in December and re-invest the minute the new year begins.
Changes in U.S. tax law in 1986 somewhat watered down that explanation, however, by failing have much impact on the January trend despite the potential to do so.
This leaves the most likely reason for stocks to have a bounce in January on so-called window dressing in December, the tendency of institutional investors to lock in gains at the end of a year to make their portfolios look good.
If that is the case, many investors appear to have decided not to put that money back to work yet in the face of slowing economies and continuing credit problems.
As regards January as a predictor for the rest of the year, however, there is no clear answer. Cooper, McConnell and Ovtchinnikov admitted they could not explain the forces behind the phenomenon.
Some analysts argue that it simply shows that markets are not as efficient as many claim and are more subject to the behavioural psychology of investors than is often granted.
Whatever the reason, markets are so far suggesting that 2008 is not going to be a smooth run.
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