January can be a time for optimism: new year, a clean slate, firm resolutions, endless possibilities. It’s natural to wonder whether that sunny outlook extends to the stock market. Enough people believe it does, and that belief has been elevated to something approaching conventional wisdom. As with a lot of conventional wisdom, though, the truth is debatable.
January Effect
The personal finance press has a catchy nickname for everything, including the belief that stocks will rise after the first of the year. They call it the “January effect.” As markets writer Adam Shell of “USA Today” explains it, one theory holds that investors brimming with optimism pour their money into the stock market, driving prices up. Other investors, hoping to get in on the gains spurred by that fresh cash, hop into the market to ride the wave, and away we go.
Another Theory
Another theory behind the January effect lays the credit — or, really, the blame — on Uncle Sam. Investors who sell stock at a profit have to pay capital gains taxes on their profit. However, you can offset your capital gains in a given year with capital losses incurred in the same year. As the year comes to an end, stock investors hoping to reduce their taxable gains start selling some of the duds in their portfolio so they can report those losses against their gains. That, the theory goes, pushes stock prices down in December. That artificial low is then followed by a rebound, and, voila, the January effect.
Some Evidence
When you start looking at hard data rather than hazy theories, the January effect gets harder to find. According to data compiled by the Federal Reserve Bank of St. Louis, the Dow Jones industrial average and the S&P 500 — two of the most widely cited measures of the general mood of the markets — both tend to rise in January. Over 20 years from 1994 to 2013, for example, the Dow rose an average of 0.3 percent in January, and the S&P 500 rose an average of 0.5 percent. Some January effect! But wait: Over the same period, the average gain for the Dow in all months was 0.7 percent, while that of the S&P 500 was 0.6 percent. How about that February-through-December effect! Meanwhile, Jim Brown of the “Premier Investor Newsletter” says his review of January data finds that the market is equally likely to rise or fall not only in the first month of a new year, but also in the first week and on the very first day.
Other Points
“Barron’s” magazine points out that the January effect is less a market-wide phenomenon than something you see with individual stocks — if a stock takes the beating in December. Tom Aspray, who writes for the “Forbes” and MoneyShow websites, acknowledges a January effect but says doesn’t apply to all stocks, and it doesn’t even necessarily occur in January. He says the stocks that are sold off at year’s end tend to be “small-caps” — stocks of relatively small companies, which don’t show up in the Dow, the S&P or the other most commonly cited market indexes. Further, once the sell-off occurs, there’s no reason the rebound (if there is one) can’t occur before New Year’s, in which case the January effect is actually a December effect.
What Is the January Effect?
The January Effect is a perceived seasonal increase in stock prices during the month of January. Analysts generally attribute this rally to an increase in buying, which follows the drop in price that typically happens in December when investors, engaging in tax-loss harvesting to offset realized capital gains, prompt a sell-off.
Another possible explanation is that investors use year-end cash bonuses to purchase investments the following month. While this market anomaly has been identified in the past, the January effect seems to have largely disappeared as its presence became known.
KEY TAKEAWAYS
- The January Effect is the perceived seasonal tendency for stocks to rise in that month.
- From 1928 through 2018, the S&P 500 rose 62% of the time in January (56 times out of 91).
- The January Effect is theorized to occur when investors sell winners to incur year-end capital gains taxes in December and use those funds to speculate on weaker performers.
- Like other market anomalies and calendar effects, the January Effect is considered by some to be evidence against the efficient markets hypothesis.
Understanding the January Effect
The January Effect is a hypothesis, and like all calendar-related effects, suggests that the markets as a whole are inefficient, as efficient markets would naturally make this effect non-existent. The January Effect seems to affect small caps more than mid or large caps because they are less liquid.
Since the beginning of the 20th century, the data suggests that these asset classes have outperformed the overall market in January, especially toward the middle of the month. Investment banker Sidney Wachtel first noticed this effect in 1942. This historical trend, however, has been less pronounced in recent years because the markets seem to have adjusted for it.
Another reason analysts consider the January Effect less important as of 2018 is that more people are using tax-sheltered retirement plans and therefore have no reason to sell at the end of the year for a tax loss.
January Effect Explanations
Beyond tax-loss harvesting and repurchases, as well as investors putting cash bonuses into the market, another explanation for the January Effect has to do with investor psychology. Some investors believe that January is the best month to begin an investment program or perhaps are following through on a New Year’s resolution to begin investing for the future.
Others have pontificated that mutual fund managers purchase stocks of top performers at the end of the year and eliminate questionable losers for appearance sake in their year-end reports, an activity known as “window dressing.” This is unlikely, however, as the buying and selling would primarily affect large caps.
Other evidence supporting the idea that individuals sell for tax purposes includes a study by D’Mello, Ferris, and Hwang (2003), which found increased selling for stocks that experienced heavy capital losses before the end of the year and more selling of stocks with capital gains after the start of the year. Further, the trade size for stocks with large capital losses tends to decrease before year-end and for capital gains after the start of the year.
Year-end sell-offs also attract buyers interested in the lower prices, knowing the dips are not based on company fundamentals. On a large scale, this can drive prices higher in January.
Studies and Criticism
One study, analyzing data from 1904 to 1974, concluded that the average return for stocks during the month of January was five times greater than any other month during the year, particularly noting this trend existed in small-capitalization stocks. The investment firm Salomon Smith Barney performed a study analyzing data from 1972 to 2002 and found that the stocks of the Russell 2000 index outperformed stocks in the Russell 1000 index (small-cap stocks versus large-cap stocks) in the month of January.
This outperformance was by 0.82%, yet these stocks underperformed during the remainder of the year. Data suggest that the January Effect is becoming increasingly less prominent.
An ex-Director from the Vanguard Group, Burton Malkiel, the author of “A Random Walk Down Wall Street,” has criticized the January Effect, stating that seasonal anomalies such as it don’t provide investors with any reliable opportunities. He also suggests that the January Effect is so small that the transaction costs needed to exploit it essentially make it unprofitable. It’s also been suggested that too many people now time for the January Effect so that it becomes priced into the market, nullifying it all together.