There are several phenomena in the stock market, that cannot be explained by standard financial theories. Most mainstream economic theories are based on the efficient market hypothesis (EMH). According to EMH, the prices in the market reflect all available information, and there is no scope for arbitrage. However, several market actions are contradictory to the EMH. Some of the examples are size effect – where small-cap stocks tend to outperform their larger peers from time to time. Similarly, value stocks tend to outperform growth stocks as described by certain ratios. There is also a similar effect with low volatility stocks. In the last several years, large-cap growth stocks have dominated the markets, but historically, many of the above effects have been observed.
Other anomalies are based on seasonality. One such effect is what is termed the ‘January effect’ - a phenomenon where January returns for many stocks are higher than the median returns for the rest of the year. The following chart is based on a historical study done by the Financial Analyst Journal and has data for a little over 100 years, based on the S&P 500 index.
As we see in the above chart, the median returns for January are higher than the median return for the rest of the month. While these might seem small absolute numbers, we have to understand that the median includes very large drawdowns such as the 1929 great depression and other bear markets.
In the same study it was observed that on average, 64% of January returns were positive, compared to 55% of the time when the rest of the month's returns average was positive.
The anomaly is seen in other markets such as Europe and Japan as well.
While the above data is compelling in terms of evidence, in recent years, the anomaly has been seen to work around at least 50% of the years.
While this provides an arbitrage opportunity and should have been arbitraged away, even the recent years data shows the January effect persists at least in some years, including 2020, 2019, and 2018.
The pandemic-driven volatility could possibly explain weak returns in January of both 2020 and 2021.
Some of the possible explanations for the effect include the following:
The exists another January phenomenon called the January Barometer – this time a leading indicator for future returns. A bull market in January results in a bull year and vice versa. Even this effect has been seen in more than 60% of the years – a topic we will discuss in a future blog piece.
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