January Effect

The January effect refers to the hypothesis explaining the tendency of stock prices to rise in January every year. This phenomenon occurring in January was first observed in stocks where small-cap stocks perform better than large-cap stocks.

The belief in this market anomaly is backed by historical evidence, and the effect has been popular among investors for decades since its origin. However, its significance is decreasing as markets have largely adjusted for its occurrence, and investment strategies based on this seasonal anomaly are no longer rewarding or highly profitable.

• The January effect refers to the theory explaining the tendency of stock prices to rise in January every year after experiencing a price drop in December. 
• The Investment Banker, Sidney B. Watchel, interpreted the effect in 1942 based on his observation of small stocks outperforming the broader market in January 1925.
• The common reasons behind the effect are tax-law harvesting, window dressing, investment using year-end bonuses, and psychological factors.
• Examples include the effect that happened and reflected in several indexes in the United States in 2019 and 2020.

The January effect theory states that the stock and other assets price in the financial market rises in the first month of every year, specifically after experiencing a price drop in the last month of the previous year. It was first introduced in 1942 by the Investment Banker Sidney B. Watchel, famous for his journal article "Certain Observations on Seasonal Movements in Stock Prices." From 1925 he noticed the small stocks outperforming the broader market in January. Furthermore, studies also revealed that the effect became smaller during the last two decades of the 20th century.

There are different reasons behind this market anomaly. Firstly, investors engaging in "tax-loss harvesting" can contribute to the effect. Tax-loss harvesting is the phenomenon of investors selling losing positions before the end of the financial year to obtain the tax benefits and repurchase them in January. This selling lowers the market price, and repurchases in January escalate the prices. Other factors include the investment of year-end bonuses in January, psychological factors motivating investors to invest at the start of a new year, etc.

Another reason to point out is the window dressing technique used by portfolio managers. Portfolio managers apply this technique before reporting the details of the holdings to the investors at the year-end. By December, they remove worst-performing stocks from the portfolio to make it satisfactory. However, they can add it again to the portfolio in January and expect a reverse in the trend exhibited by the poor performers. These acts can contribute to specific securities' price drops in December and price rises in January.

Several examples point to the uniqueness of January exhibiting higher returns and volatile nature. In many countries, December is the end of the tax year, so it hosts many significant events associated with stock trading and indirectly contributes to the stock price rise in January. Even though the effect is not guaranteed, investors can design strategies based on it by collecting small-cap stocks in December, specifically small-cap stocks with poor performance, and completing the trade or transaction in January. Let's look into the effect that happened in 2019 and 2021.

January Effect 2019

Stocks of General Electric, Mohawk, Newfield, Affiliated Managers, Coty, Xerox, Invesco, Western Digital, L Brands, Alcoa, Unum, Brighthouse Financial, and IPG Photonics underperformed the broad market in the first three weeks of December 2018, given they have not shown unattractive fundamentals, indicating that the sales and price drops are not fundamentally driven. However, most of these started recovering by the end of December 2018, beating the S&P 500. It is followed by increased investor buying enthusiasm in January 2019, driving the price of last year's underperformers upward.

January Effect 2021

At the beginning of 2021, the January effect swamped the market. Traders and investors have a tremendous feeling that all marketplaces and commercial centers will open in the coming months. The proofs pointing to the swamp are the following:

• The S&P 500 climbed 2.4%. 
• Small stocks, indicated by the Russell 200 Index, surged in January 2021.
• Oil and gas stocks are recovering after a setback in 2020.
• Gannett Co. (GCI) shares dropped 47% in 2020 has recovered 25% in 2021.
• Examples of other January effect stocks in 2021 include Occidental Petroleum, which was down 55% in 2020, gained 24% in 2021, and Continental Resources, which fell 52% in 2020 and recovered 17% during 2021.

This has been a guide to what is the January Effect. We explain the concept with examples and see how it works in the stock market. You can learn more from the following articles – 

• Bandwagon Effect
• Credit Easing
• Initial Coin Offering