By JAMES CHEN
Dec. 28, 2023
The January Effect is a perceived historical 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 widely known.
- The January Effect is the perceived seasonal tendency for stocks to rise in that month.
- In the bigger picture, since 1938, 29 out of 30 years of gains seen in January-February resulted in average yearly S&P 500 advances of 20%.4
- The January Effect is theorized to occur when investors sell losers in December for tax-loss harvesting, only to re-buy new positions in January.
- Like other market anomalies and calendar effects, the January Effect is considered by some to be evidence against the efficient markets hypothesis.
- More to the point, over the past 30 years, January gains have occurred 17 times (57%), while losing January months numbered 13 (43%), barely better than the flip of a coin.
Indeed, our own look back at the SPDR S&P 500 ETF (SPY) since its 1993 inception makes one wonder how the term ever came to be used. Of the 30 years since 1993, there have been 17 winning January months (57%) and 13 losing January months (43%), making the odds of a gain only slightly higher than the flip of a coin.12 Further, since the start of the 2009 market rally through January 2023, January months showed seven winners vs. seven losers, again a 50%-50% split. Given the strong rally from 2009, one might rightly expect a more pronounced number of January winners, but this is not the case.3
Traders should be aware of the tenuous nature of the January Effect and instead focus on the market conditions at the time and what they suggest for the overall short-term direction of the SPDR S&P 500 ETF.
Understanding the January Effect
The January Effect is a hypothesis, and like all calendar-related effects, it 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-caps 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 1942.5 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 2022 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.
The efficient market hypothesis states that share prices reflect all the information that is available to the market. Based on the theory, since all market participants have access to the same information, outperforming the market through stock selection or market timing is not feasible. The efficient market hypothesis is an argument against seasonal phenomena like the January Effect.
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 posited that mutual fund managers purchase stocks of top performers at the end of the year and eliminate questionable losers for the sake of appearance 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.
Year-end sell-offs also attract buyers interested in the lower prices, knowing that the dips are not based on company fundamentals. On a large scale, this can drive prices higher in January.
Studies of the January Effect
There have been several studies on the January Effect. One study explored the January Effect in stock prices through laboratory auctions. There were two types of auction experiments: a common value auction and a double auction market. These experiments were designed to eliminate non-psychological explanations for the January effect, focusing on psychological factors. The common value auction had participants bidding on items with unknown values, while the double auction market involved buyers and sellers negotiating prices within a specified range.
The experiments across different calendar years consistently showed that the January effect is present in laboratory auctions. The most plausible explanation is a psychological effect that makes people willing to pay higher prices in January than in December. Moreover, the study discusses and rules out several non-psychological explanations for the January Effect, such as tax loss harvesting, window dressing, liquidity hypotheses, and market microstructure issues.5
Another study discusses anomalies in general with the January Effect in particular. The study considered the January effect anomalous because it is difficult to rationalize within the standard economic framework. The study highlighted that stock prices tend to rise in January, particularly for small firms and firms whose stock prices have declined substantially over the past few years. Additionally, it notes that risk stocks earn most of their risk premium in January.
The study implies that the January Effect requires either a reevaluation of the assumptions about market rationality and efficiency or the acceptance of implausible assumptions to explain it within the existing paradigm.6
Research on the January Effect reveals a blend of psychological and market factors influencing stock prices. Laboratory experiments highlight a psychological tendency for higher bidding in January, challenging traditional financial theories. This phenomenon, particularly evident in small firms and stocks with prior declines, suggests a need to integrate behavioral insights into economic models. The January Effect, as an economic anomaly, calls for reevaluating market rationality and efficiency assumptions. Overall, these studies underscore the significance of psychological factors in financial markets and the limitations of current economic frameworks.
Criticisms of the January Effect
Studies and criticisms of the January Effect primarily revolve around its diminishing predictability, potential causes, and the evolving nature of the financial markets. These include:
- Diminishing significance: One of the most significant criticisms is that the January Effect has become less pronounced over time. As more investors become aware of this trend, they adjust their strategies accordingly, which in turn diminishes the effect. This self-neutralizing nature suggests that the January Effect may be more of a historical anomaly than a reliable future indicator. 7
- Impact of Market Efficiency: The Efficient Market Hypothesis (EMH) argues that it is impossible to outperform the stock market because market efficiency causes existing share prices to always incorporate and reflect all relevant information. As markets have become more efficient, especially with the advent of high frequency trading and sophisticated algorithms, anomalies like the January Effect are quickly exploited and corrected, making them less profitable.8
- Role of Small Cap Stocks: Critics point out that the January Effect is predominantly observed in small cap stocks, which are generally more volatile and riskier. This raises questions about the broader applicability of the effect across different market segments and the risk adjusted returns of exploiting this effect.2
- Tax-Loss Harvesting Hypothesis: The tax-loss harvesting hypothesis suggests that the January Effect is a result of investors selling securities at a loss in December for tax purposes, and then buying them back in January, artificially inflating prices. Critics argue that this behavior does not consistently occur each year and varies greatly depending on individual tax circumstances and broader economic conditions.9
- Changing Market Dynamics: The financial markets are constantly evolving with new investment instruments, regulatory changes, and shifts in investor behavior. These changes can render past patterns like the January Effect obsolete, as new dynamics emerge that were not present during the times when the effect was first observed.
While the January Effect has been a topic of interest among investors and academics, its predictability, relevance, and profitability in modern, efficient markets are subjects of ongoing debate and skepticism.
Is There Still a January Effect?
The existence and relevance of the January Effect in contemporary markets is a subject of ongoing debate among financial professionals and academics. While historically the January Effect was a pronounced phenomenon, several factors such as increased awareness and arbitrage, market efficiency as well as regulatory and structural changes have contributed to its diminishing prominence in recent years.
Can You Make Money Exploiting the January Effect?
Unlikely. Even if the January Effect were real (it's probably not) and markets were to rise uncharacteristically each January, the fact that people may try to exploit this can undermine its fruition.
What Is the January Barometer?
The January Barometer is a folk theory of the stock market claiming that the returns experienced in January will predict the overall performance of the stock market for that year. Thus, a strong January would predict a strong bull market, and a down January would portend a bear market. Actual evidence for this effect is scant.
The Bottom Line
The so-called January Effect is a market theory holding that January frequently sees regular gains for the month. The evidence for this effect is tenuous at best, with the past 30 years showing a 57%/43% split between winning months and losing months, barely better than the flip of a coin.2
Still, the January Effect is a relatively popular rationale used by market commentators to explain any positive gains in the month of January. They may attribute any buying in January to fresh buying after year-end tax-loss selling, although this is becoming less significant as most investors are in tax-sheltered investing plans.
Traders should be cautious about blindly following the mythology of the January Effect and instead focus on the current conditions leading into the turn of the year.
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- Yahoo Finance. “SPDR S&P 500 ETF Trust (SPY).”
- Nasdaq. “What Is the January Effect? And How It Can Boost Small-Caps in 2023.”
- Yahoo Finance. “S&P 500 (^GSPC).”
- CNBC. "Monthly Gains in January and February Historically Signal a 20% Average Market Advance for the Year."
- College of William & Mary. "Yes, Wall Street, There Is a January Effect!," Page 1.
- Thaler, Richard H., “Anomalies: The January Effect.” Economic Perspectives, vol. 1, no 1, Summer 1987, pp. 198-200.
- Gu, Anthony, “The Declining January Effect: Evidences From the U.S. Equity Markets.” The Quarterly Review of Economics and Finance, vol. 43, no 2, Summer 2003, pp. 395-404.
- Malkiel, Burton G., “The Efficient Market Hypothesis and Its Critics.” Journal of Economic Perspectives, vol. 17, no 1, Winter 2003, pp. 62-63.
- Bennett, Brett. “Outperforming the Stock Market Using Market Anomalies.” University of Arkansas, 2023, pp. 3-4.