January is traditionally a good time to pick up bargains, in the stock market as well as anywhere else. The “January effect” is that American stocks rise much more in January than in any other month of the year. Subsequent researchers have made many refinements and produced several ingenious explanations, usually suggesting that shares are dumped in December in response to tax or reporting requirements at year’s end.
The January effect is a challenge to the efficient markets hypothesis. A reasonably bold version of that hypothesis is that you can’t beat the market without inside information. All publicly available information—including corporate accounts, price history, and what month of the year it is—is already taken into account in the market price. A rule that says “buy on Dec. 31 and sell on Jan. 31” just shouldn’t yield spectacular returns. Yet it has.
A simple way to understand the efficient markets hypothesis is to think about the problem of finding the shortest line at the supermarket checkout. I never bother; I simply hop into the nearest line. The way I see it, if there was obviously a shortest line, people would have gone to stand in it already, and it wouldn’t be the shortest anymore. Similarly, cheap shares have been snapped up and are no longer cheap.
Taken to extremes, the efficient markets hypothesis must be false. If it were impossible to beat the market, then nobody would try, and if nobody tried, it would be easy to beat the market. In other words: If nobody bothers to look for $50 bills dropped on the pavement, there will be more than enough lying around to justify the effort of doing so.
That said, the bigger the market, the larger the rewards for even the tiniest scrap of extra insight. Exploiting a small efficiency in a billion-dollar market might be worth a million dollars. In a trillion-dollar market, the million-dollar insight could be a thousand times more subtle. The same quality of insight in your neighborhood supermarket might save you a second a year in queuing time, so you can understand why stock markets attract analytical resources and supermarkets do not. In the supermarket, then, the efficient market hypothesis might not hold. Few people will spend too much effort trying to understand the subtleties of queuing. Many shoppers may make similar mistakes, such as getting in a line with few people but failing to take into account the old lady lurking at the front with a wedge of coupons.
Yet the efficient markets hypothesis is more convincing for the stock market. Even if there are a lot of investors blundering around and making systematic mistakes, the smart investors can take advantage of their stupidity: for instance, by buying the cheap stocks in December and unloading them in mid-January. It does not matter if there are only a few smart investors, because it won’t take long before those few smart investors are managing most of the cash—natural selection at work. It also won’t take long for all the obvious mistakes to disappear, because they’ve been so exploited. Intelligent arbitrageurs cannot, however, eliminate every error in the market. True, risk-free arbitrage would require some shadow portfolio that was exactly like the S&P 500, except that it was free of whatever error was being made—they would simply sell the “no-January-effect Wilshire 5000” in December and buy the “January-effect Wilshire 5000” to replace it.
No such shadow portfolio exists, so would-be arbitrageurs need to take risks. Risky arbitrage is not true arbitrage: Rather than guaranteeing a profit, suddenly the smart investor is simply hoping for one.
That is why markets are almost efficient, but not quite. And in case you’re wondering why I didn’t tell you about the January effect in December, when the knowledge might have made you a little bit of money, don’t worry: The January effect appears to be a quaint piece of history. The arbitrageurs are already standing in front of you in the shortest line in the supermarket.