Believing in seasonal effects in stock markets might seem like clutching at straws. However, there is good evidence to suggest psychology plays a large part in market moves, especially over the short term. The mere hint of an improvement or deterioration in the outlook for a company can see its shares move rapidly and certainly before any proven change in the outlook.
As investors, we also know that it is a good deal easier to buy shares when prices are trending higher and the news flow is good. Conversely, buying as a crisis strikes and prices have fallen is considerably more difficult, even when shares have become fundamentally cheaper.
It follows that our human frailties might be detectable in some seasonal patterns too, and January seems as good a place as any to begin.
The problem is that even if some seasonal effects do occur, they usually aren’t reliable enough to act upon. They also have a habit of being too small to cover the costs of buying and selling at precise moments.
Shrinking seasonal effects are to be expected the better known they become, as any anomalies are traded away in the weeks and days leading up to when they are supposed to occur.
But the biggest problem is that when seasonal patterns fail, they can do so spectacularly, wiping out the minimal profits of many prior years when they worked out.
However, in the case of the most popularised version of the January effect or, more correctly, the January barometer – as goes January, so goes the year – it may be something to bear in mind in conjunction with other factors.
Most of us probably feel a difference returning to work in the New Year compared with the run-up to Christmas. So, shouldn’t that also affect how favourably or otherwise we view the prospects for shares and funds?
There’s also the possibility that the bonuses individuals may receive at Christmas result in more investment buying in January. Even so, there has to be a certain leap of faith to suppose optimism or pessimism born in January will last the entire year.
One fairly easily actionable January effect is the outperformance that smaller company shares are supposed to exhibit in January or even the first quarter of the year.
If the January effect holds good for shares generally, this makes some kind of sense. Smaller company shares are less liquid than blue chips, meaning excess buying in January might be expected to have a greater effect on their share prices.
From a more fundamental perspective, stock markets have at least two important factors in their favour this year. First, share valuations have fallen since the end of 2021, making the reasoning for a further fall based on overvaluation grounds less easy to justify. It’s relatively rare for markets to fall two years in a row.
True, there are recession risks after the sharp increase in interest rates last year. On the other hand, central banks at least have some leeway to reverse policy if needed, a luxury not afforded them when interest rates were at rock bottom.
Secondly, history shows that stock markets tend to pre-empt a recovery in earnings growth. In other words, shares tend to start to bounce back even as the growth in company earnings is still falling. So, while earnings forecasts may continue to decline this year – especially if recessionary conditions take hold – that need not mean a further fall in share prices.
In the US – which accounts for around two thirds of the world’s stock markets by value – analysts currently expect earnings to increase by just over 5% this year – similar to the earnings growth projected to have been achieved in 20221.
January effect or not, perhaps the best approach investors can take is to be aware of possible seasonal drivers of share prices while remaining focused primarily on the long-term growth and income stock markets can provide.
It makes sense to maintain a balanced portfolio of investments able to take the rough with the smooth and come out on top over the longer term.
Source:
1: FactSet, 15.12.22
