January Effect in 2010 Stock Market

So what is all of this talk of the January Effect?  By Wikipedia’s definition it is “a calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.”

Therefore, the main characteristics of the January Effect are an increase in buying securities before the end of the year for a lower price, and selling them in January to generate profit from the price differences.

This type of pattern in price behavior on the financial market supports the fact that financial markets are not fully efficient.

The most common theory explaining this phenomenon is that individual investors, who are income tax-sensitive and who disproportionately hold small stocks, sell stocks for tax reasons at year end (such as to claim a capital loss) and reinvest after the first of the year. The January effect does not always materialize; for example, small stocks underperformed large stocks in January 1982, 1987, 1989, 1990, and 2008.

So how much impact has already been felt in January 2010?

Further theoretical explanation of the January effect, and it’s corollary small-cap outperformance observation, is that retail investors who are tax sensitive choose to take capital losses during the month of December, and then after the 30 day wash rule waiting period buy the stocks back in January. Further interpretation suggests that the selling pressure on small stocks from tax selling creates buying opportunities in these “sold off” stocks that is taken advantage of in January. In any event, over the last 85 years most years do record a first half January outperformance of small cap stocks.

This year there have been no losses that people either have or want to take in December. Most taxable investors took losses last December. This year only those that have held stocks through the market cycle still have losses to take. Those long term investor are most likely heartened by the performance of their stocks since March and therefore probably will not sell them to take significantly smaller losses than they had on paper a year ago. People who bought stocks during 2009 , in general, have few losses to take.

There are, however, lots of investors who have short term gains. This is the group that is torn. They fear a correction, but their greed is not fully fulfilled yet. The first wave of these trader/investors will have long term capital gains in April and May. They may want to wait until then to sell. However, if they see a big correction start they may want to sell early next year to lock in profits that they won’t pay tax on until April of 2011.

The real question is whether buyers and sellers in aggregate foresee enough economic challenges coming to warrant selling early next year. Will this group start a correction early in 2010, or will the continued march of a self-sustaining economic recovery keep them locked into stocks as they recognize that we are still very early in a new market cycle.

We still are dedicated to three steadfast rules of rebuilding your net-worth that we have now been chanting for six months. We believe that those that follow these rules will look back in five years with great satisfaction at their decisions.

1.) Don’t sell into corrections, buy more when they happen.

2.) Start investing in stocks in international stock markets.

3.) Keep bond maturities short.