The January sharemarket effect: Enjoy whilst it lasts

The ASX is off to a flying start in 2012, writes The Motley Fool. Could it be the January effect in play again?

For investors who search for seasonal patterns in the share market, a dependable rule for making profits year in and year out is the Holy Grail of investing. Yet while no seasonal indicator is perfect, some of them carry substantial weight among investors — and thereby often become self-fulfilling prophecies.

One such indicator is the so-called January effect. But despite its name, you increasingly have to become aware of seasonal plays long before they’re slated to take effect, as otherwise, more intrepid investors will beat you to the punch.

Why January matters
The January effect isn’t a newly discovered phenomenon. According to The Wall Street Journal, the January effect has been around for decades — but it still commands the attention of profit-seekers.

Over the years, academics and market analysts have worked to define more precisely the exact nature of the January effect on shares. From its origins as a simple observation that shares tended to have better returns in January than in other months, closer examination of the effect suggested that it was more dramatic among smaller shares, especially those that had suffered substantial losses during the year.

Speculation about the justification for the phenomenon still abounds without any definitive answers. The Journal article suggests that U.S. tax-loss selling plays a role, as late sellers dump their big losers from their portfolios but then can’t buy them back until after the new year starts. The resulting cyclical wave of selling pressure in December and buying pressure in January leads to the familiar pattern of share performance.

An attempt to play the effect
As with most seasonal share movements, however, the bane of the January effect is its popularity. As more people track the phenomenon, its effectiveness wanes. But if the underpinnings of the January effect are accurate, then early discovery should merely move its price action rather than eliminating it entirely. In other words, there’s hope that if you’re early enough to the game, you can still reap the benefits of the phenomenon.

Should you bother?
More importantly for most investors, however, is the fact that the January effect is short-lived. Since it only deals with anticipated short-term results of around a month, it isn’t much use to anyone with a longer-term time horizon. Any gains you reap from the effect would be short-term gains subject to tax at your full normal marginal rate. Combine that with the inherent uncertainty over whether the phenomenon will actually work in any given year, and it seems like a big price to pay for what essentially amounts to a gamble on shares.

Seasonal factors are fun to look for, even if they aren’t terribly reliable. This year, pay attention to the January effect and see if it plays out, but don’t bet the farm on it.

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