January Effect

Jennifer BautistaAlexandra Stone

Rosa Stoveld

History of the January Effect The January effect is a calendar-related anomaly in

the financial market where financial securities 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.

The January Effect was first observed in, or before, 1942 by investment banker Sidney B. Wachtel. It is the observed phenomenon that since 1925, small stocks have outperformed the broader market in the month of January, with most of the disparity occurring before the middle of the month.

History of the January Effect Banz and Reinganum (1981) report a

significant negative relationship between abnormal returns and market value of common equity. They assume that the negative relation between abnormal and returns and size is stable.

Brown, Kleidon and Marsh (1983) report a reversal of the size anomaly for certain years and reject the hypothesis of stationary year-to-year abnormal returns attributable to size.

The Study

This study examines the month-to-month stability of the size anomaly over the period from 1963 to 1979.

The evidence indicates that nearly 50% of the average magnitude of the risk-adjusted premium of small firms relative to large firms over this period is due to anomalous January abnormal effects.

26% of the size premium is attributable to large abnormal returns during the first week of trading in the year and almost 11% is attributable to the first trading day.

Evidence on anomalous excess returns In this study the anomalous negative

relation between firm size and abnormal risk-adjusted returns are investigated.

Beta estimates that adjust for non-synchronous trading and trading infrequency in the computation of abnormal returns are employed.

Data and portfolio selection The data for this study are drawn from the

CRSP daily stock, from 1963 to 1979. That sample consists of firms which were

listed on the NYSE or AMEX and had returns on the CRSP files during the entire calendar year under consideration.

Each year all sample firms are ranked based on the market value of their common equity and then they are divided into ten portfolios.

Sensitivity of the size anomaly to trading infrequency Rolls (1981) maintains that since the shares of

small firms are generally the most infrequently traded and the shares of large firms are the most frequently traded, the betas for small firms are downward biased while the betas of large firms are upward biased.

Reinganum (1982) reports that, while the direction of the bias in beta estimation is consistent with these adjusted betas will still exhibit a pronounced negative relation to firm size.

The Size Anomaly There is no distinguishable relation between the

OLS estimates of beta and firm size measured by market value of equity.

Although the Scholes-Williams beta estimates for smaller firms are generally higher than the corresponding OLS estimates, there is still no distinct ordering of the betas according to firm size.

The Dimson beta estimate for the portfolio of smallest firms is significantly larger than the largest firm portfolio beta, and there is a near monotone declining relationship between firm size and Dimson beta.

The size anomaly: Some empirical results based on Scholes-Williams beta estimates

Average daily excess returns (in percent), size measured by market value of equity, beta estimates and autocorrelations

of excess returns for ten portfolios constructed from firms on the NYSE

Portfolio Average excess return Market value of equity OLS beta Scholes-Williams beta Dimson beta

1st order autocorrelation of

excess return

Smallest 0.08 4.40 0.76 0.92 1.47 0.22

  -10.38          

2 0.03 10.50 0.87 1.01 1.47 0.13

  -5.83          

3 0.02 18.90 0.91 1.03 1.43 0.07

  -3.88          

4 0.00 30.30 0.93 1.08 1.42 0.03

  -0.97          

5 -0.01 46.70 0.99 1.08 1.42 0.03

  ( - 2.24)          

6 -0.01 73.40 0.98 1.08 1.30 0.10

  (-4.82)          

7 -0.02 118.10 0.95 1.03 1.27 0.18

  ( - 6.40)          

8 -0.02 210.20 0.97 1.04 1.22 0.28

  (-6.74)          

9 -0.03 433.00 0.96 1.02 1.12 0.35

  ( - 7.20)          

Largest -0.04 1092.10 0.96 0.97 0.98 0.35

  (-7.19)          

Average daily abnormal returns

Smallest 2 3 4 5 6 7 8 9 Largest

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3 Tests1. Seasonality of the monthly average return2. Seasonality in observations in the smallest

and largest portfolios3. Non-stationary mean abnormal returns and

autocorrelation

Size-related Anomalies and Stock Return Seasonality

CRSP daily stock files From 1963-1979 Firms listed on the NYSE or AMEX

◦ 1,500 (1960’s) to 2,400 firms (late 1970s)

Data

Common stock prices follow a multiplicative random walk

= the random portfolio return μ = expected return for the info set = iid random variable with mean 0 Implies: portfolio returns are time invariant Further Research: Accounts for months Results: large monthly returns in January

Previous research

Rt e t

Rt

e t

Rt m e t

Keim (1982) Plot the negative

relation between abnormal return and firm size for each month

Clear difference for January

Magnitude of January Returns Related to Firm Size

January average size effect = 15% Other months = 2.5%

Further support

Data : 10 market portfolios of NYSE-AMEX stocks from 1963-1979

Null Hypothesis: expected abnormal returns for each month are equal

Rt - average daily CRSP excess return for day t Dit - dummy variable indicating month ex =

February ai - the excess return for the month If Null Hypothesis is true, then:

◦ ai’s should be close to zero◦ F-statistic measuring the joint significance of the

dummy variables should be insignificant

Test 1 : Seasonality of the monthly average return

Rt a1 a2D2t a3D3t ... a12D12t et

Results

Null Hypothesis: mean abnormal returns for the largest and smallest portfolios are the same

Results: Reject Ho Smallest firm:

◦ F-stat = 14.59 ; significant at any level Largest firm: F-stat = 17.63

◦ Abnormal returns were negative and lower all other months

Observed size premium in January is positive and significantly larger

Test 2: Seasonality in observations in the smallest and largest portfolios

First Trading Day◦ Difference in abnormal returns between the

largest and smallest portfolio average = 3.2% ; st dev = 2%

◦ Positive every year◦ Accounts for 10.5% of the annual size effect

First Five Trading Days◦ Ave = 8%◦ Accounts for 26.3% of the annual size effect

January Effect and the First 5 Trading Days

Period Ave Jan diff in monthly % abnormal returns btw smallest and largest portfolios

T-statistic

1963-1968 9.7 10.2

1969-1973 11.3 9.1

1974-1979 23.1 13.0

Year to Year Stability

• 1969-1973 – large firms outperformed small firms (except 1971)

Null Hypothesis – non-stationary mean abnormal returns may cause autocorrelation

Use an ordinary least squares method of regression

Rt (mean-adjusted abnormal return) is used to compute autocorrelations

Test 3 : Non-stationary mean abnormal returns and autocorrelation

Rt a1 a2D2t a3D3t ... a12D12t et

Not significantly different from zero Reject Null Hypothesis

Test 3 Results

Small Portfolio

Large Portfolio

All observations 0.189 0.320

W/o Jan observations

0.187 0.274

Tax loss selling hypothesis Information hypotheses Neither hypotheses has been linked

theoretically or empirically to the January effect

Hypotheses of the January effect

January returns are larger than normal due to year-end tax loss selling of shares that have lost value during the previous year

Small firms are more likely to participate in tax loss selling

Not supported theoretically or empirically◦ Theoretically: arbitrage possibilities in non-segmented

markets with non-taxable investors◦ Empirically: Magnitude of January effect should vary

with level of personal income tax rates Example – January effect should have been smaller after

WWII because personal tax rates were low, but it was actually larger

Tax Loss Selling Hypothesis

Investors are motivated to reduce their year-end tax liability by selling stocks that have declined in value and use the realized losses to offset capital gains

This causes value of stock to decrease because of selling pressure at the end of the year and to return to equilibrium in January

Tax loss selling hypothesis

January is a month of uncertainty because of the expected release of previous year performance

The release of financial information during the month of January can have greater effects on small sized firms versus large firms because large firms are able to collect data more quickly and effectively

This hypothesis can be tested by event (fiscal year-end) versus calendar date

Information Hypothesis

Not related to economics Possibly due to:

◦ Outliers◦ Concentration of listings and delistings at year-

end◦ Data base errors

Alternative Explanations

Investigations of CAPM show the existence of anomalous abnormal returns that are negatively related to size

Daily abnormal return distributions in January have larger means in relation to the other 11 months

Relation between abnormal returns and size are always more negative and pronounced than the other 11 months

50% of the average magnitude of the size anomaly from 1963-1979 were caused by abnormal returns during the month of January◦ More than 50% of January premium was caused by large

abnormal returns during the 1st week of January (majority occurring on the 1st day)

Conclusion

Questions?