January Effect: What It Is in the Stock Market, Possible Causes

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 widely known.

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. Further, since the start of the 2009 market rally through January 2022, January months showed eight winners vs. six losers, again a split of 57% to 43%. Given the strong rally from 2009, one might rightly expect a more pronounced number of January winners, but this is not the case.

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. 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.

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 and Criticism

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 such seasonal anomalies 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 has also been suggested that enough people know about the January Effect that it has become priced into the market, nullifying it altogether.

Other researchers have found that January Effect still exists, but only for smaller-cap stocks, owing to a lack of liquidity and interest from investors.

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.

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, e.g., 401(k)s.

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.