To provide readers with interesting information and insights about the financial markets, FXCE will publish many articles on different topics. Today we will introduce a phenomenon quite interesting to those participating in the stock market: the January effect.

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What is the January effect?

The January effect is a phenomenon where stocks tend to rise more during January compared to other months. The January effect is only a short-term cycle, often seen in small-cap and low-priced stocks. This phenomenon occurred in the last sessions of December of the previous year and continued in January of the following year.

Experts attribute this price increase to an increase in buying volume, following a decline in prices that usually occurs at the end of the year as investors engage in tax losses to cover capital losses. so they sell out, reducing the stock price.

Another explanation is that investors took advantage of year-end bonuses to buy other investments the following month. Cause the price of the stock to increase at the beginning of the following year. However, this phenomenon seems to gradually disappear as it becomes more common.

This is probably a positive sign, as it creates an opportunity for investors to buy the stock at the lows of December last year and sell again after the price increases the following year.

Learn more about the January effect

With financial markets, we don't talk much about feeling or chance; we need to pay attention to the numbers. So how do you know? January effect, Is it true or just an unfounded myth?

Let's take a look at the data from the SPDR S&P 500 ETF, a group of US stock exchange-traded funds. The fund was established in 1993, and in the 30 years since its establishment, there have been 17 winning January's (57%) and 13 January losses (43%), with the difference being not too much. The January effect is only relative, like when you toss a coin.

Moving on from 2009 to 2022, in January, the number of winners versus losers was 8-6, again about 57% to 43%. 2009 was a year of recovery for the market, but there were not many outstanding victories. Here we only see the January effect, which is still quite fragile.

As with other economic theories, the January effect, as a hypothesis, affects small-cap stocks more than mid- and large-cap stocks because of lower liquidity. However, it is not without foundation when people believe in this theory. Take a look at the following information for an explanation:

The History of the January Effect

To give a bit of context, in the 20th century, investment banker Sidney Wachtel first noticed the January effect in 1942. He looked at data starting in 1925 and observed that small-cap stocks tended to perform better than large-cap stocks. With most of the outperformance occurring in the first half of January.

Since then, various studies have been conducted to examine the extent of the January effect. For instance, Wahctel's observation was supported by a later study that analyzed market return data from 1904 to 1974. The study found that stock returns were significantly higher in January, about five times higher than in other months. 

Another survey by Salomon Smith Barney showed an average January gain of 0.82% comparing small-cap versus large-cap returns from 1972–2002. However, this trend has gradually become weaker in recent years due to the correction of the market. The January effect is a well-founded hypothesis, but it is not completely accurate and is only true for small-cap stocks. And in recent years, it may have been gone.

What causes the January effect?

There are many different reasons for this price movement. In today's article, we will focus on some of the most common causes of the January effect.

Investor sentiment

Market investors are generally more optimistic about the future. They think that the beginning of the year is the right time for trading activities. Therefore, investors will start building a portfolio of stocks.

Plus, year-end is the season of bonuses. When there is an extra balance, investors will plan to start buying shares at the beginning of next year. It is this that has contributed to the phenomenon of the January effect.

Tax loss harvesting

At times like the end of the year, investors often tend to sell underperforming stocks to cover losses and reduce income tax. This causes the selling price of shares to decrease because many people are selling simultaneously. But at the beginning of the following year, they will return to reinvest and buy shares. This led to a substantial increase in buying pressure, causing the price to increase in January.

Window Dressing 

Some people think that the Window Dressing trick is also the cause of the January effect. Window Dressing refers to beautifying a business's financial statements before they are published on the outside.

Managers will eliminate losing stocks to "beautify" their records around the end of the year. This also makes the number of shares sold at the end of the year increase gradually. However, this also does not happen often.

Should we believe in the January effect?

Several studies have confirmed that the January effect exists. However, it’s been inconsistent across decades, and some criticize its diminishing impact over time. In recent decades, the January effect may have gradually disappeared because of new policies and changes. 

The introduction of social regimes such as retirement and new tax regimes has made the trading of exploiting tax losses decrease. The anticipation of the January phenomenon, combined with a market correction, has rendered the January effect obsolete.

For long-term buy-and-hold investors, trying to capitalize on the January Effect is likely not a worthwhile strategy. Remember that for long-term investing, the most important driver for building wealth is more time in the market. 

This means it’s far better to get invested early and stay invested than to try to time your purchases around certain months. Even if this trend were to continue in the future, it shouldn’t alter your investment strategy in any meaningful way. 

However, if you assume the effect is real in some market segments and are looking to add new positions in small-cap stocks, one potential strategy could be to buy in December instead of January, when prices tend to rise on average. 

That said, market timing based on seasonal trends may do more harm than good. Instead, a buy-and-hold strategy focused on long-term investment goals is likely to be the most effective approach. Therefore, be cautious about making short-term predictions based on the calendar.

The answer is that we should not apply the January effect to profit from the stock market. Even if this phenomenon is real, with the constant volatility of the market and too many people trying to exploit it, the results will change and lead to unforeseen risks.

Conclude

In general, the January effect is the positive movement of the stock market in January. However, this theory is only suitable for small-cap stocks and is likely to no longer hold soon.

Stock investors should not invest too much in January to avoid risks and losses. The market is always volatile, so you shouldn't be too confident in a certain hypothesis.

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