December 30, 2011

If you’ve never made a New Year’s resolution, you’re in the minority: One 2006 study found that more than 80 percent of those surveyed had once promised to, say, eat, smoke or spend less after Jan. 1. Unfortunately, research also shows that 80 percent of these resolvers fail. Why do they make promises they can’t keep? It’s new year optimism — the idea that, whatever happened between February and December, things will be better in January.

It’s no different on Wall Street. We start the new year thinking that, as we become better people, our investments will perform better as well. In a recent paper in the Journal of Behavioral Finance, I connected January optimism to an overall rise in stock prices. The results were clear: Whether in boom times or in recession, bears hibernate in January, and positive-thinking bulls run free.

This “January Effect” has long been a mystery to market analysts. The market isn’t supposed to behave like another irresolute new year’s resolver. Despite being uncovered in 1942 by economist Sidney Wachtel and widely publicized after a 1976 study by professors Michael Rozeff and William Kinney, the phenomenon persists.

Two popular hypotheses try to explain these unusual returns. One is “tax-loss selling” — the notion that investors sell stocks in December to generate capital losses for their tax returns, then buy them back in January, pushing up prices temporarily. The other, “window-dressing,” contends that money managers sell risky holdings in December to make portfolios look safer when reporting to clients. After the ball drops, they buy back what they sold, pushing January prices up.

Both explanations have their supporters, but neither adequately accounts for the January Effect. Cheap stocks whose prices rose during the year are unlikely candidates to be sold for tax reasons, but they also do well in January. Meanwhile, window-dressing does not appear to occur during mid-year reporting dates. If money managers were doing this at the end of the year, they would probably do it in the middle of the year, too.

January optimism fills the gaps in these theories. I found that small stocks, such as those with market caps below $1.5 billion in the Russell 2000 Index — think Starbucks before the latte craze — were particularly predisposed to its influence. Because they are considered risky, temporarily optimistic investors bet on them at the beginning of the year. When reality sets in, these holdings get dumped.

January optimism is sentimental — and sentiment-based arguments are generally ignored by academic researchers who frown upon claims that clash with their ideas of market efficiency. In perfect markets, prices convey all available information about an equity, and no investor should consistently beat a market index such the Dow Jones Industrial Average or the S&P 500. Wall Street, where portfolio managers earn millions picking winners, knows this isn’t true; brokers can leverage January optimism and reap big gains for their firms before Presidents’ Day.

But what about the 99 percent who aren’t working on Wall Street? How can ordinary investors take advantage of the January Effect? Follow the herd and be optimistic — purchase cheap, long-shot small stocks in December, and sell them before they tank in February.

Of course, there is no guarantee that the January Effect will continue. Then again, there’s no guarantee that those who promise to read “War and Peace,” practice yoga or call their mothers every Sunday won’t be hard at work on their resolutions 30 days from now. Odds are, however, that January optimism will wither — stock prices will fall, Tolstoy’s weighty tome will go unread, yoga mats will gather dust, and Mom will wait by the phone.

stephen.ciccone@unh.edu

Stephen Ciccone is a professor of finance at the University of New Hampshire.