January Effect Chills Investors with Gloomy 2008 Outlook

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By Mike Caggeso
Associate Editor

If you believe in the January Effect, you're probably feeling rather glum right now.

In essence, the trading theory holds that the first five trading days of the New Year pretty much set the tone for the 12 months to come. In fact, since 1970, whenever the Standard & Poor's 500 Index ends the first five trading days of the New Year with an aggregate gain, the broad-based bellwether has gone on to notch a full-year gain in 31 of the those 37 years – or 84% of the time, according to Money Morning research.

Trading experts theorize that stocks often post gains in the first five trading days of the New Year because, in the weeks prior, many investors "clean house" – that is, sell shares to establish tax losses, to reshape their portfolios, or to raise cash for holiday shopping. And that depresses stock prices in December, positioning them to subsequently rebound as January begins.

This year may be different. The fragile U.S. economy stymied any chance for a New Year surge, and actually forced the three key U.S. indices down into the red.

In the first five trading days of the New Year, which ended with the market close yesterday (Tuesday), the Dow Jones Industrial Average Index fell 5.09% (675.75 points); the tech-laden NASDAQ Composite Index dropped 7.98% (211.77 points); and the broader Standard & Poor's 500 Index posted a 5.32% loss (78.18 points).

"The recent action on Wall Street and on global markets is very negative because you would expect positive returns at this time of year," Mark Hirschey, a University of Kansas professor who has studied the January Effect, told the Financial Times.

How Portentous is the January Effect?

Interestingly, although a positive start usually points to a positive year, when the first five trading days are negative – as they were this year – there actually isn't a statistical bias in either direction.

But there's a caveat: The next milestone that investors must watch for is how the markets perform for January as a whole. Yale Hirsch of the Stock Traders Almanac has said that every time the S&P 500 posted a loss for January, a flat market – or a new, extended, "bear market" – followed.

Hirsch also said that a loss for January is followed by a market decline for the year that averages 13%.

Hirsch speculates that the January Effect has been so well chronicled that it actually now starts in mid-December – a manifestation now labeled as the Santa Claus Rally. So now, when bargain hunters emerge in the last few trading days of the year, they're hoping to get the jump on those early market timers.

The "Other" January Effect(s)

In 2005, Michael Cooper [University of Utah], John McConnell [Purdue University] and Alexei Ovtchinnikov [Virginia Polytechnic Institute] researched "The Other January Effect," which states that the yearly performance of small-cap businesses are especially tied to how their stocks fared in the first five trading days of the year.

"Over the period 1940-2003, when the CRSP value-weighted (VW) market return in January is positive, the VW market return over the next 11 months averages 14.8%; when the VW market return in January is negative, the VW market return over the next 11 months averages 2.92%, giving rise to a spread of almost 12%," their report said. "Street lore has been confirmed. Or, at least, it appears to have been confirmed."

Their research also mentions a several other related theories – most of them much more controversial. They include the value effect, turn-of-the-year effect, the overreaction/under-reaction effect, the Presidential Election Cycle Effect, the Halloween Indicator, and the preposterous Boston snow indicator.

Of course, if all else fails, there's always the Super Bowl Winner Theory and a study of women's hemlines – out there for use as tried-and-true proven market predictors.

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