Does January doom spell a year of gloom?

The “January Effect” is an interesting piece of share market theory – and relevant to us as we come to the end of a volatile January of trade on share markets worldwide.  It refers to two different share market effects that people have observed. The first is that shares in the USA, especially small company shares, tend to have a positive return over the month of January. There are various explanations for this, including that this is in relation to tax based trading in December and January. The second January Effect, sometimes referred to as the “Other January Effect”, is that the return from shares in January might be predictive of how the market performs over the rest of the year. That is, if January provides a positive return for investors, that helps predict positive returns for the rest of the year – and visa versa.

In 2006, Cooper, McConnell, and Ovtchinnikov, in an article published in the Journal of Finance, used USA share market data from 1940 to 2003 to find evidence that January stock returns did have some predictive ability through the rest of the year in that market.

This “Other January Effect” is a particularly interesting proposition for investors – with shares seemingly likely to have a negative return in January to start this year, is this something that we can use to help us predict returns for the rest of 2016? Does it provide evidence that now (after a poor January of returns) is the time to move to cash, forget about the volatility, and relax for the rest of the year as the value of shares fall, before buying back into shares once we see what January 2017 holds?

To consider whether this Other January Effect holds in Australia, we have looked at Australian share market data (in calendar years) from 1990 through to the end of 2015. This provides 26 years of data. We have then looked at just the share market return for the month of January, before considering whether the return from January (positive or negative) then helped predict the rest of the year.

Before looking at the results, it is interesting to consider what result we need to see before we might consider that January share market returns are actually a useful tool to predict the share market return for the whole year. AMP did some analysis of the returns from the Australian share market from 1900 to 2008, finding that there were 21 years (19 per cent of the time) that share market returns were negative. Interestingly, this is almost exactly the same as our 1990 to 2015 results, with has seen 5 of 26 years (19 per cent) having negative returns. On this basis, we could just predict that each year will have positive returns, and be correct about 80 per cent of the time. Therefore, to provide a level of prediction greater than this, the Other January Effect has to be able to predict the correct results more than 80 per cent of the time.

The following table sets out the results for the January Effect from 1990 to 2015:

The results are damning for the Other January Effect over this period in the Australian share market – only managing to predict future market directions 50 per cent of the time – it's no better than a coin toss. Interestingly, it has been spectacularly wrong at times after a negative January. In 1993, a negative return in January was followed by a year of 40.5 per cent returns from the Australian share market. More recently, a negative January return in 2009 was followed by a 37 per cent return for the remainder of the year.

Conclusion

If January returns were predictive of the returns for a year, it would be an invaluable tool for Australian investors. Given the high likelihood of a negative return for January this year, it is particularly relevant. However, looking at data from the last 26 years in the Australian market, the returns from January don't seem to help us predict the future direction for share market returns over the rest of the year.