January Effect

The Layman’s Definition: The "January effect" has been used to refer to the phenomenon in which small-cap securities often have had higher rates of return in past Januarys than large-cap stocks. This tendency of the stock market to rise is noticed between December 31 and the end of the first week in January.

The Reason(s):

There are a number of theories as to why the January effect has occurred.

Some people speculate that it may be related to the many year-end research reports on the small-cap market, which can make these stocks look like attractive places to put money.

Another theory says that investors who need cash for the holiday season will sell some holdings; bargain hunters then swoop in to buy the sold-off shares.



And the most prominent among all is: The effect may be related to tax-motivated selling and buying -- fund managers might rush to buy back all those money-losing stocks they had previously sold to meet the tax-loss deadline. That is many investors choose to sell some of their stock right before the end of the year in order to claim a capital loss for tax purposes. Once the tax calendar rolls over to a new year on January 1st these same investors quickly reinvest their money in the market, causing stock prices to rise. There is some evidence for this one, as there isn't proof of a January effect before 1913, when taxes were introduced. And in Australia, where the tax year actually ends in June, stocks show a "July Effect."



The Brief History:

In 1976, using an equal-weighted index of NYSE prices, Rozeff and Kinney, reported evidence of a seasonal pattern in stock market returns. From 1904 through 1974, the average stock market return during the month of January was 3.48 percent whereas the monthly return during the remaining 11 months of the year was 0.42 percent. January returns appeared to be more than eight times higher than returns for a typical month. Because the equal-weighted NYSE index represented a simple average of the stock prices for all listed companies, the Rozeff and Kinney methodology gave small companies greater relative influence than would be true in a value weighted index, where large companies dominate. Indeed, subsequent research by Reinganum (1983) and Roll (1983), among others, confirmed that this January effect is a small-capitalization phenomenon. Various studies have suggested that the January effect may arise from the prevalence of end-of year “window dressing” by professional investors seeking to eliminate embarrassing losers from their portfolios prior to the end of important reporting periods. For example, Lakonishok, Shleifer, Thaler, and Vishny (1991) argued that portfolio returns are noisy, so sponsors examine individual portfolio holdings to gain additional perspective on an investment manager’s investment philosophy and execution. According to this window-dressing hypothesis, institutional investors are evaluated on both their investment results and the consistency of their investment philosophy. At the end of the calendar year or any important reporting period, institutional investors may be prone to sell losers and buy winners to improve perceived performance.



A reasonable assumption, however, is that window dressing by large institutional investors, if present, would be a large-cap phenomenon. So, the window dressing hypothesis may have limited relevance for explaining the January effect if the effect is restricted to small-cap stocks. At the level of the individual investor, Ritter (1988) found that end-of-year price movements of small companies tend to be related to the buying and selling habits of “small” investors. He argued that during December, individuals apparently sell stocks that have declined in price to realize the tax losses. These investors then apparently wait until January to reinvest (in a broad cross-section of small-cap stocks) because January buying can be augmented by cash infusions from year-end bonuses or from the sales of large-cap stocks on which long-term capital gains are being realized. By focusing on the abrupt switch to net buying by individual investors at the turn of the year, Ritter offered a “parking the proceeds” explanation as to why the January effect is largely confined to smallcap stocks, especially small-cap stocks that performed poorly during the prior year. In findings consistent with this hypothesis, D’Mello, Ferris, and Hwang (2003) observed abnormal selling pressure prior to the year-end for stocks that experienced large capital losses and observed that individual investors postpone the sale of stocks that experienced capital gains until after the New Year. There also appears to be a significant decrease in the average trade size for stocks with large capital losses before the year-end and for stocks with capital gains in the New Year. These findings suggest that individuals, rather than institutional investors, are the major sellers around the year-end and that individual tax-loss selling is the fundamental explanation for abnormal January returns.



The summons:

This stock rally of increase in price during month of January is generally attributed to an increase in buying, which follows the drop in price that typically happens in December when investors, seeking to create tax losses to offset capital gains, prompt a sell-off. – Investopedia

The January effect is said to affect small caps more than mid/large caps.

It's true throughout history; small stocks had obliterated large stocks in January.

There is no comparison. From 1925 to 1993, small stocks beat large stocks in January in 69 of the 81 years.

Even more amazing, the return difference has been about FIVE percentage points… (roughly, big stocks had returned 2% in January, and small stocks returned an astounding 7%).

On the surface, the January Effect appears like a promise of "free money" during that month - just buy on the last trading day in December and sell on the last day in January, and collect a 7% return.


The Weakening Logic: The effect was first suggested in 1942, and widely publicized in the past 25 years by scholarly articles and a popular book entitled “The Incredible January Effect: The Stock Market's Unsolved Mystery", by Robert A. Haugen and Josef Lakonishok. Perhaps due in part to publicity and anticipation of the effect, the January effect has weakened in recent years.

This historical trend, however, has been less pronounced in recent years because the markets have adjusted for it. Another reason the January effect is now considered less important 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.

The January Effect Since 1994: Completely Worthless

* 1994 Small stocks lost to large stocks
* 1995 Small stocks lost to large stocks
* 1996 Small stocks lost to large stocks
* 1997 Small stocks lost to large stocks
* 1998 Small stocks lost to large stocks
* 1999 Small stocks lost to large stocks
* 2000 Small stocks lost money
* 2001 Small stocks BEAT large stocks AND made money!
* 2002 Small stocks lost money
* 2003 Small stocks lost money
* 2004 Small stocks BEAT large stocks AND made money!
(Russell’s 2000 Index for small stocks, and the Dow for large stocks.)

Since 1994 the median return on small stocks in January has been -0.2%. Said another way, since 1994, the January Effect has been a money-losing strategy.