Is the January Effect real? | Everything you need to know

The January Effect is a trend where stock prices rise in January following an end-of-the-year sell-off. The true cause of the effect is still up for debate, but there are several popular theories.

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What is the January Effect?

The January Effect is an assertion that stocks often receive a boost in the month of January that overperforms month-over-month growth seen during the rest of the year. This calendar-related effect is thought to be caused by an increased number of buy-ins at the start of the year after sell-offs in December cause stock prices to dip.

The January Effect was first observed by investment banker Sidney B. Wachtel in 1942 when he noticed stocks performed best during the beginning of the year, typically in January.

Is the January Effect real?

The January Effect does appear to be real. Since Wachtel’s claim several studies have supported his theory. According to the global investment management firm Schroders, this phenomenon has occurred in 80 of the past 130 years in the US stock market, and it’s occurred even more often in UK, Japanese, and Australian markets. These positive returns are also on average higher in the month of January than other month of the year.

The effect seems to be stronger on small-cap stocks compared to large-cap stocks, according to the Corporate Finance Institute’s analysis of the Russell 1000 and Russell 2000.

However, the trend has diminished since Wachtel made his theory public. The shrinking difference between January stock results and other months lends credence to the efficient markets hypothesis, which states stocks do not deviate from their fair market value by things such as psychological factors. While the exact cause of the January Effect or why it is declining has never been found, there are several popular ideas.

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What causes the January Effect?

The cause of the January Effect is still unknown, but there are several prominent theories. However, these theories each have their own holes in logic, which we dive into below.

Tax-loss harvesting

Tax-loss harvesting is done by investors to avoid taxes on capital gains by offsetting them with capital losses. By realizing losses on underperforming stocks, you can reduce any gains you might have also realized and lower the amount of taxes you’re required to pay.

Why might it cause the January Effect?

Because taxes on capital gains are determined at the end of the calendar year, investors often sell off their losing stocks in December. The reported losses are added to their gains and shrinks the amount of taxable income received from their investments. Investors must wait 30 days before reinvesting the money into similar stocks, meaning the capital realized from selling those gains and losses typically does not reenter the market until January – which could lead to the effect.

Why might it not?

The use of tax-loss harvesting has waned with the emergence of tax-shelter retirement vehicles that investors can move their capital gains in to avoid taxes. These vehicles involve 401ks and Individual Retirement Accounts (IRAs) in the US, the Registered Retirement Savings Plan (RRSP) in Canada, and a Self-Invested Personal Pension (SIPP) and Individual Savings Account (ISA) in the UK. With these new options, tax-loss harvesting becomes obsolete for many.

Window dressing

Window dressing is a strategy used by mutual fund and other portfolio managers to sell off losses from a portfolio and reallocate that money into well-performing stocks at the end of the year. These new stocks are then reported as part of the fund’s holdings to investors in place of poor-performing ones, making the funds appear more successful than they are.

Why might it cause the January Effect?

The reallocation of funds into positive performing stocks can give them an even higher boost and create abnormal returns for January since window dressing occurs in late December. The reallocation mimics that of tax-loss harvesting and creates the same movement of capital out of the market in December and back into the market come January.

Why might it not?

While some investors may window dress, the idea that it has created a calendar-effected anomaly is highly unlikely. Also, the growing number of passive funds has lessened the opportunity for window dressing by fund managers – as these funds aim to mimic certain indexes, not outperform them. So even if window dressing was one cause during Wachtel’s time, it is not likely to be one today.

Psychological factors

Another possible driver of the January Effect is the psychology of new investors. It has been suggested some people see the start of a new year as an opportunity to begin investing, slightly inflating the market. In addition, year-end bonuses often hit bank accounts in January and may then be directed to the stock market.

Why might they cause the January Effect?

These psychological factors only occur during the start of a new calendar year, and its common advice to invest large bonuses. While analysts still haven’t found direct causation for the January Effect, hard-to-explain psychological factors become more popular as an answer.

Why might they not?

These psychological factors are hard to prove, and the widespread knowledge that prices might jump in January now allows more investors to adjust for it, one psychological factor diminishing another. Plus, a huge amount of money would need to be added to the market this way to influence the performance of a particular stock or index.

How does the January Effect impact the stock market?

The January Effect impacts small and mid-sized enterprises (SMEs) much more than larger organizations. Why? Because it takes fewer investors to affect share prices of small-cap stocks because of their low liquidity.

Small-cap stocks also take longer to rise after mass sell-offs because fewer investors are watching them, meaning price drops caused by December selloffs may not be exploited by investors until January. Meanwhile, large-cap stocks can rebound much faster, often in a matter of hours or days.

While a spike in movement can still be seen in these smaller stocks during January, it has slowly smoothed out as more traders have taken notice of this calendar-related anomaly. Proponents of the efficient market hypothesis argue modern markets work too seamlessly to be affected by external concerns beyond the value of the underlying company, and in this case they may be right.

Trading the January Effect

The strength of the January Effect has slowly dwindled ever since it was first discovered by Wachtel. So, attempting to profit solely from this anomaly is uncommon. Furthermore, the more traders who attempted to capitalize on the January Effect by buying stock in December in anticipation of a rise, the lower those gains would be since there would be fewer sell offs in December.

You may better use your time analyzing other fundamental factors related to the January Effect at the turn of the year such as the Santa Clause Rally, or by using the sleepy Holiday trading season to brush up on technical analysis skills.

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