Will the Fed interest rate decision derail the January market bounce?

Stock market performance is systematically stronger during the month of January, a phenomenon known as the “January effect.” This happens because investors want to "harvest tax losses to offset the gains they accumulated earlier in the year," explains Gerald Jensen, professor of economics and finance at Creighton University in Omaha. 
 
"Specifically, toward the end of the year, investors realize losses by selling depreciated stocks. These losses are used to offset gains investors realized on appreciated stocks sold earlier in the year,” he says. "After the turn of the year, investors are anxious to put their funds back to work in the market. Thus, they combine the funds obtained from end-of-year stock sales with funds received from end-of year bonuses to purchase stock.”
 
 
But the Fed's decision to raise interest rates could put a damper on an otherwise great opportunity for investors.
 
“In our research, we identify a factor that can potentially derail a January panacea for small, out-of-favor stocks, and that factor is the actions of the Federal Reserve. As we argued in our book, Invest with the Fed, investors should always be vigilant of Fed policy actions because the Fed controls the purse strings for the economy," he says. "An increase in the federal funds rate signals that the Fed is implementing a tighter monetary policy, i.e. closing the purse strings, whereas a decrease in the funds rate indicates an opening of the purse strings.  Of course, no change indicates the Fed is maintaining the status quo." 
 
Consider the following table, for example: 
 

 

January Return

 

Year

Small Stocks

Out-of-Favor Stocks

Change in federal funds rate *

2011

4.08%

6.23%

-0.01%

2012

10.89%

13.78%

-0.01%

2013

8.82%

12.83%

0.00%

2014

4.31%

3.53%

-0.01%

2015

-1.71%

-3.82%

+0.03%

2016

-9.29%

-10.33%

+0.12%

* Change in effective federal funds rate from November to December

 
Jensen explains: "The table reports January returns for small stocks, and separately, for out-of-favor stocks over the six most recent years. Each portfolio performed well over the first four years when Fed policy was easing or steady; however, during the final two years when Fed policy was contracting, the portfolios experienced negative returns.  A portfolio that combines the two firm characteristics (i.e. small and out-of-favor) compounds both the positive returns in the earlier years and the negative returns in the two subsequent years.  In the past two years, it appears that the Fed has derailed the traditional January stock price bounce.  The evidence is particularly persuasive for January 2016 when Fed actions significantly raised the federal funds rate, which coincided with a substantial negative return for both portfolios."
 
"It is likely that the Fed will once again serve as the spoiler and derail the January market bounce, as it did in the prior two years," he adds. "For investors, the decision the Fed made today may determine whether it plays the role of Santa Claus or Scrooge during this Christmas season."

Source Contact Information

Institution:
Creighton University
Title:
Professor of Economics and Finance
Email:
GeraldJensen@creighton.edu
Phone:
402.280.3391