The Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ all experienced unusually high rallies in January. According to CNN Money, this was the largest January rally since 1997 for the DJI and the S&P 500. Ultimately a demand for shares at higher values causes upward movement in stock market indexes, but what drives that demand explains why it happens. Several variables influenced this stock market performance, and when compounded simultaneously, these factors can cause an upwardly aggregated demand for shares at higher price levels.
January effect
The January effect is a rise in stock prices at the beginning of January per the NASDAQ. The reason it occurs in January is because portfolio managers want to reacquire stocks after having sold stocks for tax purposes at the end of the previous year. Although this effect has been discounted as less relevant it has in year’s passed been synonymous with annual rallies. Moreover, since the January effect is statistically correlated with the stock market’s annual performance, investors believe it is a good omen and therefore allowing buy orders to be filled at higher prices. However, according to Lara Hoffman of Forbes, this premise is faulty because similarities do not necessitate predictive capacity.
Central banks
Central banks can also influence the stock market. For example, the European Central Bank recently implemented large long-term refinancing operations or LTRO which allow banks to refinance pre-existing debt at low rates.. These low-rates helped ensure financial liquidity and appease market fears of credit crisis. U.S. Federal Reserve monetary policy can have a similar affect by keeping the cost of investment capital low for large institutional investors. According to CBS News, a Federal Reserve Announcement that interest rates would be extended through 2014 contributed to January’s rally.
Market behavior
There is a saying used by stock traders, “Don’t fight the Fed”. This is used when central bank activity is a recognized contributor to stock market activity and helps fuel a bullish market psychology. Price momentum also adds the equation via the phrase, “The trend is your friend.” In other words, if the current trend is upward, the momentum of that trend has more weight than downward pressure on stock prices. This in turn builds confidence in making buy, rather than sell decisions. In January there was an upward momentum in stock prices that was strong enough to resist considerable economic data to the contrary, an example being a World Bank report that downgraded economic forecasts in developed countries.
High frequency trading
High frequency trading or HFT algorithms are designed to make money regardless of any economic reality, and account for 60 percent of all stock market trades according to the New York Times. The computational power of HFT algorithms allows them to take advantage of buy and sell patterns with accuracy and speed. The net affect of these algorithms could have compounded the January affect by taking advantage of the January effect’s trend with greater force and trading determination. Additionally, since high frequency trading leads to a reduction in transaction costs per a Bloomberg-Businessweek report, trading stocks at slightly higher prices can be offset by those lower transaction costs.