Commentary on financial markets – January 2018
Highlights:
- MiFID II enters into force.
- Strengthening euro puts the brakes on European stock markets
Commentary:
Equity and commodity markets have had a great start to 2018. In January, US equities thrived, benefiting from President Trump’s approved tax reform. However, the traditionally more volatile emerging market equities did even better, with Russian and Brazilian stocks, for example, rising by a strong +12% on average! Thus, January, which tends to be indicative of year-round performance, was one of the highest-growth Januarys in 30 years.
At the beginning of January, the European MiFID II directive came into force, pushing for increased transparency of financial products for retail clients. In practice, this will mean handing over more documents to the client when investing in mutual funds.
The performance of European equity markets has been hampered by the strengthening euro as well as the reversal of the ECB’s monetary policy. The bank did not try too hard to correct the strong euro at its last meeting and, moreover, has repeatedly proclaimed confidence in inflation growth. This confirms to the markets that it expects quantitative easing to taper off in the autumn. It will be interesting to compare the ECB’s inflation forecasts over the course of the year with actual price growth net of food and energy prices, whose weakness does not confirm the bank’s forecast at all. But ECB bankers, according to their latest comments, are more likely to express their determination to slow monetary expansion further anyway. This is supposedly to reduce the financial risks of low interest rates (credit growth and overheating of some local property markets).
Investor School – January Effect:
The January effect is an empirically observed regularity whereby January stock returns are often statistically above average compared to other months of the year.
One of the first studies to demonstrate this phenomenon was published in 1976 by Michael S. Rozeff and William R. Kinney, who analyzed NYSE-listed stocks over the time span 1904 to 1974. They concluded that the average monthly performance of this market during January was +3.83% compared to a normal return of +0.24% in other months. The authors found no other period during the entire year with such a significant anomaly. In 1983, Donald B. Keim tracked the historical series of some national stock exchanges and his main finding was that the above-average January return was more strongly related to so-called small caps , i.e., stocks of small companies with small market capitalizations. Another important paper confirming the January effect was a study by Richard J. Rogalski, published in 1984, who found that anomalous stock price behaviour in January tends to occur during the first five trading days of a given market.
Why? Of course, all the gentlemen mentioned above have also been trying to get to the bottom of the whole thing. The first, and for a long time the only fully accepted explanation, was the impact of the peak tax-optimization transactions at the end of each December. This explanation starts with the claim that share prices that have fallen during the year are depressed further at the end of the year as investors try to realise capital losses to minimise tax payments. Once the year is over, this pressure ceases and prices return to intrinsic values. However, these conclusions have been challenged by several confirmations of the January effect in countries where there is no possibility of reducing tax liability by capital loss deduction and in countries with slightly different tax regimes. Moreover, it is easier to realise a capital loss over one or two days than to undergo several days or weeks of price fluctuations. The explanation for the January effect is therefore the sharp increase in liquidity on the stock market, which is linked to the mass reallocation of institutional and individual portfolios, changes in investment strategies and the updating of return estimates for individual investment instruments.
The January effect is a statistically confirmed regularity, but it is obviously not valid in all cases. For example, the months of January were very bad in 2006-2016.
A wise investor should not fall prey to seasonal patterns that repeat with a certain percentage probability and still carry risk, but should build his portfolio for the long term, taking into account his risk profile and investment horizon.