January Effect Definition
The January effect, also nicknamed the January barometer, is a calendar effect specifically in relation to the stock markets anomaly experienced in the month of January, which is characterized by an increase in stock prices.
A market anomaly refers to the distortion in stock prices from the expected performance, as set out by the efficient market hypothesis (EMH). Whereas, a calendar effect, on the other hand, refers to a market anomaly that is related to a specific day, month or any time of the year and with a frequent tendency.
It should be noted that the month of January generally tends to be a good season for the markets overall. However, the January calendar effect as a hypothesis would prove that the financial markets as a whole are inefficient and therefore the month does not offer investors with any right arbitrage opportunities.
According to, Burton Malkiel, – An ex-Director of Vanguard Group, and the author of “A Random Walk Down Wall Street,”- he states that the January effect doesn’t last long. Also, even if it was to be exploited by buying stocks in large quantities to sell or the opposite, the transaction cost involved dips into the profits that were to be realized.
A Little More on What is the January Effect
The January effect was first noticed by renowned investment banker Sidney B. Wachtel at around 1942. In his observation, he noted that small stocks kept outperforming the large stocks with most of this unexpected performance occurring before the middle of January. From Wachtel research, he noticed a consistent pattern since the year 1925.
Wachtel’s observation was supported by a study that analyzed the markets data for over seventy years running from 1904 to 1974. The study discovered that the return on stocks was five times greater, especially with small-capitalization stocks, during January than in any other month.
Further, to support the existence of the January effect, a different study analyzing data from 1972 to 2002 conducted by investment firm Salomon Smith Barney found out that some stocks outperformed by 0.82 percent during January but underperformed throughout the entire year. The investment firm research discovered small-caps stocks (as measured by the Russell 2000 index) outperforms large-caps stocks (Russell 1000 index) possibly due to the January effect.
However, this market phenomenon in recent years it has proven far more difficult to profit from, as it seems the market has adjusted to it and therefore it is less pronounced. The January effect is a hypothesis and does not always materialize as expected. For instance, research data shows that small caps underperformed large caps in January of 1982, 1987, 1989 as well as in 1990.
As from the year 2016, market analysts have considered the January effect as less significant to market performance for reasons such as;
- People no longer need to sell stocks for a tax loss due to the availability of tax-sheltered plans such as 401(K)s and IRAs.
- With the market anomaly having been in existence for long, so many investors anticipate the mid-January effect, and so the markets have over time adjusted to it with no reliable opportunities to exploit.
Nevertheless, the adjustment has, in turn, created another market anomaly in December called the Santa Claus rally- where many investors buy stocks that are low priced in order to try and take advantage of the January effect by selling at increased prices. Whereas, both the Santa-Claus rally and the January effects are trends worth monitoring, anyways, it should be noted that market analysts generally agree that they are not a reliable way for investors to reap easy short-term earnings.
Possible Explanation for the January Effect
Various market factors have been presented as the likely reason for the stock gain experienced in January by small listed firms. Researchers from AQR Capital have established that small stocks have generally outperformed large ones by an average of 2.1 percent in January from 1926 to recently in 2017. The reason for this market rally includes;
- Investor Psychology – Many individual investors follow up on New Year’s resolution starting from January, and the momentum and energy associated with the need to start investing for the future rally’s a peek in the stock market.
- Window dressing – This is when an institutional investor such as a mutual/hedge fund managers go shopping at the end of the year for stocks that have outperformed in order to deceive individual investors that they have a successful portfolio while in essence, they made losses.
- tax-loss harvesting –Traders or individual investors frequently dump stocks at the end of the year so that they can claim capital losses. These massive year-end-sell-off drives prices down. Consequently, it also attracts investors interested in the low rates, and as a result, driving prices back up in January.
- Repurchases – Those engaged in tax –loss harvesting in December make stock repurchases in January; and also investors use year-end cash bonuses usually paid in January to invest in the market, therefore, causing the January effect.
Benefits of the January Effect
Despite the view that the market rally provides minimal profitability, due to its short period and substantial transaction cost that literally eliminates profitability in buying and selling or the other way round. However, if you look at January on a market cap weighted basis, the effect is still more pronounced. Possible benefits that can accrue to stock investors include;
- Predictable seasonal fluctuation that typically spans December and January, enables stock traders to account for certain price variations and take advantage of market volatility in determining the possible entry and exit points and expected profitability.
- Presents an opportunity to make the most of the year end losses which can later be declared as a loss on an investor’s next tax return.
- An opportunity to reinvest money from year-end tax selling in December, but in hopefully more profitable stocks.
- Presents an opportunity for investors to take advantage of the year-end bonuses to invest in small cap stocks in January immediately they are in receipt of the fund.
There are other seasonal market anomalies too, such as the July effect and many others. However, the way the January effect helps small stocks and hinders large ones in terms of price run-up is particularly interesting. Nevertheless, if you are a momentum investor, then January may prove to be a challenging month with little stock arbitrage.
Momentum investment is buying stocks that have had a price rally over the years but in a consistent manner. These portfolios of stocks tend to continue to perform, that is, consistently gain momentum in performance. In contrast, the January effect doesn’t last and guarantees no momentum.
Still, investors looking to add small companies to their portfolio should consider doing so in late December in order to maximize on the January effects possible benefits. Besides, small stocks are less expensive and more profitable in the long run as they tend to outperform over time according to research.
Of course, they don’t deliver consistently; it should be understood that the markets are inefficient, but over time, research suggests they can improve investment performance. So, how does an investor effectively take advantage of the January effect? Below are some suggestions;
- Select small firms (small-cap stocks) – the January effect is more pronounced with small-cap stocks possibly because they are less liquid. Therefore an investor should identify a small company as an investment vehicle.
- Have a risk strategy –Develop a good plan and if possible get a trading journal and track the approach that works for a robust trading plan which will mitigate risks involved.
iii. Know when to buy and sell – Investor should perform due diligence before executing a trade, by considering factors such as a stock’s past performance in recent days, weeks, months and prior years and backing it up with reliable research. This will ensure that the entry and exit point in a trade provide enough profit margins.
- Stay up to date – be informed of the happenings around the stock markets, having an RSS feed is ideal as an investor will have vast and reliable news sources delivered fast to guide one in investment decisions.
- Focus on either short or long positions – There are available opportunities in either direction depending on your timing and the size of the stock. However, an investor should not often switch between the two. If you typically focus on short positions, then stick with in order to reap maximum possible benefits.
- Get professional advisory – If as an investor you are totally green to the stock markets, it should be noted that the markets are highly volatile with a potential risk of losing all the funds invested. The most appropriate call is to get a professional to do all the hard work for you at a fee.
In conclusion, debates will always be there as to whether the January effect holds any ground as an opportunity to exploit the market or it’s just a market rally with nothing special about it. Either way, investors should strive to make informed choices because the markets as stated earlier are not efficient enough to guarantee consistency.
References for January Effect
Academic Research on January Effect
Anomalies: the January effect, Thaler, R. H. (1987). Journal of Economic Perspectives, 1(1), 197-201. The paper looks at evidence concerning the January effect as a whole from an economist perspective and whether the January effect can be independently rationalized as an anomaly.
The January effect: Still there after all these years, Haugen, R. A., & Jorion, P. (1996). Financial Analysts Journal, 52(1), 27-31. The paper looks at the year-end disturbance in the prices of small stocks, that is, the January effects and examines data that suggests that there is no change in this market anomaly. The article indicates that the January effect has been a consistent market rally.
The january effect, Haug, M., & Hirschey, M. (2006). Financial Analysts Journal, 62(5), 78-88. The paper discusses the January effects and analyses the possible impact on the stock markets and generally the underlying factors that contribute to this calendar effect.
Can tax‐loss selling explain the January effect? A note, Jones, C. P., Pearce, D. K., & Wilson, J. W. (1987). The Journal of Finance, 42(2), 453-461. The paper examines tax loss harvesting by investors during the end of the year and whether it is a possible reason behind the January effects characterized by increased prices in small-cap stocks in the United States markets.
The declining January effect: evidences from the US equity markets, Gu, A. Y. (2003). The Quarterly Review of Economics and Finance, 43(2), 395-404. The paper examines the declining trend of the January effect by looking at data the Dow 30 and the S&P 500 for the post-war period through the 1970s. Also, the article examines the relationship to the actual growth in gross domestic product, inflation, as well as the market volatility in the U.S equity market and presents its findings.
Tax‐loss selling and the January effect: evidence from municipal bond closed‐end funds, Starks, L. T., Yong, L., & Zheng, L. (2006). The Journal of Finance, 61(6), 3049-3067.The paper presents evidence from the municipal bond closed‐end funds that suggest that tax loss selling to offset capital gains by investors is a contributing factor to the overall January effect.
The January effect and aggregate insider trading, Seyhun, H. N. (1988). The Journal of Finance, 43(1), 129-141. The paper analyses possible explanation to the January effect such as the compensation for the higher risk of trading as well as predictable changes anticipated by traders at the turn of the year.
Macroeconomic seasonality and the January effect, Keamer, C. (1994). The Journal of Finance, 49(5), 1883-1891. The paper looks at the Macroeconomic seasonality in relation to the January effect and presents possible explanation models for returns experienced during the period.
Personal income taxes and the January effect: Small firm stock returns before the War Revenue Act of 1917: A note, Schultz, P. (1985). The Journal of Finance, 40(1), 333-343. The paper asserts that before the introduction of the War Revenue Act of 1917 there is no relation between the January effect drive. The effect only becomes more pronounced after the inception of the War Revenue Act of 1917.
All things considered, taxes drive the January effect, Chen, H., & Singal, V. (2004). Journal of Financial Research, 27(3), 351-372. The paper asserts that tax loss harvesting by tax-sensitive investors drives the January calendar effect in the United States more than any other possible explanation for this market anomaly.
Emerging stock markets return seasonalities: the January effect and the tax-loss selling hypothesis, Fountas, S., & Segredakis, K. N. (2002). Applied Financial Economics, 12(4), 291-299. The hypothesis tries to establish a link between the seasonal market anomaly called January effect and tax loss selling associated with the markets at the end of the year. The hypothesis examines stock returns in eighteen emerging stock markets for the period 1987–1995.
The other January effect, Cooper, M. J., McConnell, J. J., & Ovtchinnikov, A. V. (2006). Journal of Financial Economics, 82(2), 315-341. The paper looks at the January effect and its relationship with a possible indication of expected performance for stocks throughout the year. The article examines data from over the period 1940–2003 and finds that the January effect has predictive power for market performance over the next remaining eleven months of the year.
New evidence on the January effect before personal income taxes, Jones, S. L., Lee, W., & Apenbrink, R. (1991). The Journal of Finance, 46(5), 1909-1924. The paper asserts that tax- loss harvesting is the reason behind the January effect; primarily it followed the introduction of the income tax in 1917. The article examined data from Cowles Industrial Index stocks before and after the introduction of the income tax.