The January effect is a term market mavens use to classify the first month of the year as the best-performing month, stock-wise, on the annual calendar.
Some speculators claim that stocks have the largest price increase in the first month of the year, relative to any other month. But is there anything to that claim? This article will explore the history and possible causes behind the January Effect.
Is the January Effect Real?
Are financial markets affected by seasonality trends? Yes and no. There is some hard data on the topic that does support the existence of the January effect, but most recently, January 2021 was definitely a mixed bag.
According to Schroders, a global asset management firm, in 85 of the past 130 years (up to 2020), the U.S. stock market rose in value. In global stock markets, the same trend follows, with the U.K. showing a 71% market uptick rate in January and Japan reporting a 74% gain level over the same time period, Schroders reports. And in Australia the stock market has finished positive in January 78% in the past 130 years.
Most recently, the 2021 January effect wasn’t very evident. According to data from S&P Dow Jones Indices, here’s how stocks largely performed in in the month of January, 2021:
• The S&P 500 Index was down 1.11% in January, although the one-year return showed a gain of 15.15%.
• The Dow Jones Industrial Average fell by 2.04% for the month but gained 6.11% for the one-year period.
• The S&P MidCap 400 Index rose by 1.45% for the month and gained 16.59% for the one-year period.
• The S&P SmallCap 600 rose by 6.24% in January with a one-year return of 21.32%.
Given the mediocre results from January 2021, with the larger stock indexes in the red for the month, veteran market watchers may wonder what happened to the stock market January effect, which proponents say leads to solid market gains during the first month of every year.
History of the January Effect
The phrase “January effect” is largely credited to Sydney Wachtel, an investment banker who coined the term in 1942. Wachtel noted that small stocks seemed to perform better in January, a trend he first noticed in 1925.
It wasn’t until the 1970s, however, that the notion of a faster-moving stock market in January earned mainstream acceptance, as analysts and academics began rolling out research papers on the topic.
Why is January a Good Month for Investing?
Here are a few reasons why stocks may indeed rise in the first month of the year.
Tax Loss Harvesting
January is more of a buyer’s month than December, where many investors are selling to lock in year-long gains or to get rid of dead-wood stocks and take advantage of year-end tax strategies (more commonly known as “tax loss harvesting”).
With tax loss harvesting, investors can write off their losses on a yearly basis, with the tax timetable ending on December 31. According to U.S. tax law, an investor only needs to pay taxes on the total value of their investments.
For example, let’s say an investor owns stocks in three companies. It’s the total value of the profit and loss that winds up being taxed.
Company A: $20,000 profit
Company B: $10,000 profit
Company C: $15,000 loss
For tax purposes, the investor can tally up the total investment value of all three stocks in a portfolio—in this case, that figure is $15,000 ($30,000 minus $15,000.) Consequently, the investor can claim a total stock portfolio value of $15,000 by December 31.
If the investor still believes in Company C, he or she can repurchase the stock 30 days after the December 31 tax harvesting deadline, in order to avoid the wash sale rule (outlined in our article on Day Trading Strategies), which prevents investors from benefiting from selling a security at a loss and then buy a substantially identical security within the next 30 days.
Changing of the Guard in Election Years
In major election years, stock market investors may take a wait-and-see stance in October and November, until they see which regime will be in office and can once again resume buying with Congress and the Presidency often getting a “fresh start.”
A Clean Slate for Consumers
U.S. consumers, who have a robust say in how the American economy will perform (as measured by gross domestic product (GDP), traditionally view January as a fresh start. Adding stocks to the portfolio—or adding to existing equity positions—is one way consumers hit the New Year’s Day “reset” button.
Portfolio Managers Tend to Buy In January
The month of January gives mutual fund managers a chance to wipe the slate clean and buy new stocks, bonds, and commodities for the new year and get rid of losing stocks. That puts managers in a position to get a head start on building a portfolio that has a good yearly-performance figure, and thus add more investors to their funds.
Small-cap Stocks Tend to Rise
Another indicator of strong stock market growth is with small caps, where evidence mounts that January is a big month for small caps. Historical data from Salomon Smith Barney showed that small-cap stocks were reliably stronger than large-cap stocks in January, based on data studied from 1972 to 2002.
January Effect and Efficient Markets
When reviewing facts and figures that back up the theory behind the January effect, investors may well decide that the January market trend is real, and invest accordingly—primarily by actively buying stocks as early as possible in a new calendar year.
But that strategy is at odds with the idea of efficient markets. An efficient market is where the market price of securities represents an unbiased estimate of the investment’s true value.
Efficient markets backers say that external factors—like the January effect or any non-disciplined investment strategy—aren’t effective in portfolio management. Efficient market theorists also don’t believe that calendar-based market movements have any effect on market outcomes.
The best strategy, according to efficient market backers, is to buy stocks based on the underlying value of the company—and not based upon dates in the yearly calendar.
Like other market anomalies and calendar effects, the January Effect is considered by some to be evidence against the efficient markets hypothesis. Nevertheless, there is evidence that the stock market actually does perform better in January, especially with small cap stocks.
Whether one believes in the January effect or not, it’s always a good idea for investors to use strategies that they feel can best help them meet their long-term goals.
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