Explaining the January Effect		By Dr Chua Hak Bin Traders adore market abberations as it spells arbitrage and opportunity. And the January Effect is one abberation that has repeated time and time again despite the phenomenon being public knowledge. The January Effect refers to the rally that occurs especially in small-capitalisation stocks in the month of January. From 1926 to 1995 in the United States, small-cap stocks outperformed large-cap stocks in the month of January 56 out of 69 times. The effect was especially strong before 1983, the year when the anomaly was first documented. The returns have fallen since, as investors capitalised on this seasonal pattern. While the outperformance of small caps over large caps from 1926 was 5.1 percentage points higher, the performance from 1983 was only about 2 percentage points higher.
The January Effect in the Malaysian Stockmarket?
The February Effect
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Chinese New Year, Bonuses and Credit Constraints
Regional Patterns		Explaining the January Effect   Researchers believe the January Effect is tied to tax-loss selling at year-end. The capital losses are utilised to offset capital gains and to reduce the overall tax obligations. Investors will then rush to place their proceeds back into the stockmarket in the new year, resulting in the January Effect. The effect shows up most dramatically for small-caps as these stocks show the greatest price volatility. The tax-loss selling explanation however is not well accepted. The January Effect has been well documented in Canada since 1954; the only problem is that the capital gains tax was only introduced around 1970. Similarly, if tax-losses are responsible, the January Effect should take place in April in Australia, which it doesn't. Some economist also find a January Effect for the KLCI from 1970 to 1988 despite the absence of any capital gains tax. The effect weathers out however if the period is extended to 1996. Other explanations for the anomaly ties back to window-dressing by fund managers but the evidence is by no means conclusive.   The January Effect in the Malaysian Stockmarket?   Is the January Effect observed in Malaysia? Investors caught in the pullback of the Second Board are desperately looking for a silver lining, with many banking their hopes on a January rebound for small caps. We examine data for the Second Board Index since 1993, the year when it first became available, and data for the KLCI over the last ten years. Percentage changes are calculated on prices over the month of January. The data suggests that the January Effect, in contrast to many Western markets, does not take place in the Malaysian stockmarket (Table). On the contrary, in 3 out of the last 4 years, the Second Board index fell. And on average, it fell about 4 percent in the month of January. The Composite Index similarly does not show any definite pattern in January over the last 10 years.   The February Effect   If there is any seasonal pattern at all in Malaysian share prices, February would be the most promising month. In the last 10 years, the KLCI has risen 8 out of 10 times in February, with an average rise of 2.6 percent. However, this effect is considerably weaker if a longer period from 1970 to 1996 is used. What is notably dramatic is the February performance of small caps. The Second Board Index has risen 4 out of 4 times in the month of February, with a spectacular average increase of 8.6 percent over the month. In the last two years, the Second Board Index had risen 7.2 percent over the month. As the Second Board Index came about only 4 years back, the number of observations is still too small to jump to any firm conclusion, but the evidence is suggestive.   TABLE 1: NO JANUARY EFFECT, BUT BANK ON FEBRUARY (% Change in Index During the Month ) \ MONTH OF JANUARY MONTH OF FEBRUARY Year KLCI Second Board KLCI Second Board 1987 + 10.8 - + 13.0 - 1988 + 8.6 - - 1.4 - 1989 + 9.3 - + 0.6 - 1990 - 0.3 - + 2.6 - 1991 - 0.8 - + 0.3 - 1992 + 3.4 - + 5.1 - 1993 - 1.3 - 5.4 + 1.6 + 14.1 1994 - 14.1 - 18.0 - 2.0 + 5.9 1995 - 8.9 - 12.9 + 5.7 + 7.2 1996 + 6.3 + 20.3 + 1.1 + 7.2 Average + 1.3 - 4.0 + 2.6 + 8.6   Chinese New Year, Bonuses and Credit Constraints   A reasonable explanation for the February Effect is the timing of the year-end bonuses, which for many Malaysians, takes place just before the Chinese New Year festivities in February, rather than December or January. Bonuses have been especially large in the last few years given the strong performance of many companies and the tight labor market. Some stockbroking companies boast bonuses as generous as 24 months. Part of these bonuses are ploughed back into the stockmarket resulting in a February Effect. This explanation can also account for the stronger performance of the small caps. As the buying is retail-based rather than foreign or institutional-based, the effect is more pronounced on Second-Board counters, which given its liquidity and small paid-up, are also more easy to move. If there is such an underlying latent demand for small caps, why isn't the buying taking place even before in January or December, and instead concentrated in February? The main explanation may be a result of credit constraints. Retailers still face credit constraints in their stock purchases especially when it comes to small caps, as margin financing may not be readily available for most investors. With the strong positive cashflow in February, such credit constraints are inevitably relaxed.   Regional Patterns   Detecting the January or the February Effect in the other Asian stockmarkets is difficult as the effect is most pronounced only in small-cap stocks rather than composite-linked stocks. As such, an investigation of the more easily available composite indices in these markets show no definite pattern in these 2 months. A natural hypothesis to test from the Chinese New Year or February Effect is the price behaviour of small-cap stocks in the Hong Kong or Singapore stockmarket as company bonuses are also largely given out before the Chinese New Year, bearing in mind however that credit constraints may be less of a concern in these two wealthy cities. However, the unavailability of small cap indices in these countries prevents a test of the Feb Effect.   Conclusion: A February Rally for Small Caps?   An understanding of this seasonal anomaly in the Malaysian stockmarket may also provide an explanation for the January Effect in the US and Canadian stockmarkets. Certainly, a common explanation which may be driving both the January and the February Effect is more believable than two separate explanations for the two somewhat related phenomena. The tax-loss selling hypothesis clearly does not apply to the Malaysian stockmarket. Barring a better explanation, year-end bonuses during the Chinese New Year festivities provide the most sensible hypothesis for the February Effect. Otherwise, the historical February rallies for small caps must be dismissed as just another fluke. Dr Chua Hak Bin is a senior executive in a KLSE-listed company. The author would like to thank Patrick Zecha, Research Head at South Johor Securities, for his comments. The opinions expressed are solely his own. ( Go Top ) ( Back To Left Brain )
Conclusion: A February Rally for Small Caps?
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