In a recent post, we introduced the January effect: higher equity returns in January. Today, we dig more deeply into the reasons for the (nowadays obsolete) market anomaly.
How Do You Feel in January?
In their 2018 International Review of Financial Analysis paper “The January sentiment effect in the U.S. stock market”, Chen and Daves analyze the relation between individual investors sentiment, asset allocation, and subsequent stock returns. Following an earlier paper, they term this relation the January sentiment effect (JSE). As their investment universe, they consider the entire CRSP stock universe from January 1978 to December 2017 and compute excess market returns. The index of consumer sentiment (ICS), which measures expectations of future consumption, is their main explanatory variable.
Why Should January Sentiment Predict Returns?
Behavioral finance research suggests that investors overreact to current information when making financial decisions. Investors’ New Year’s resolutions lead to re-evaluations, and reallocations, of their asset allocations (Doran et al. 2012). Thus, investor sentiment affects stock markets: A bullish outlook in January may lead to higher equity investments and drive up stock prices.
And, Does It Predict Returns?
In a first step, Chen and Daves relate ICS changes as the explanatory variable to subsequent monthly excess returns. To control for the economic environment, they include unemployment rates, inflation proxies, and a dummy for crisis intervals. To account for the general January effect, they also include a dummy that takes on a value of one if the January return is positive, and zero otherwise. Table 1 provides the regression results.
|ICS change (January)||0.19***||0.18***|
|ICS change > 0 (January)||0.76*|
|January return > 0||0.57||0.30|
Table 1 displays the impact of sentiment changes on subsequent stock market returns from February to December. Coefficient estimates are multiplied by 100 for ease of exposition. *** and * denote significance at the 1% and 10% level. Source: Table 3, Chen and Daves (2018).
Table 1 shows that January sentiment increases predict future higher stock market returns (Model 1), even when controlling for positive January returns (Model 4). A one-unit increase in sentiment increases market returns by 20 bps. Also, years with increasing sentiment in January have 76 bps higher subsequent returns (Model 2). Interestingly, the January effect is not significant (Model 3).
Portfolio Management Implications
Additionally, Chen and Daves analyze the impact of January sentiment (ICS changes in January) on riskier stocks. The JSE has a more significant impact on stocks with higher MTB, stocks of smaller firms, and lower firm performance. Consistent with this relation, the authors conclude that riskier stocks are more sensitive to sentiment. Hence, investors invest more in risky stocks when they are more bullish in the beginning of the year.
Take-away: All’s well that starts well?
Since sentiment at the beginning of the year plays a crucial role, we can conclude that irrational exuberance in January affects investor portfolios over the entire year – January sentiment sets the tone for the whole year.