January Effect
A recognized increase in the prices of stocks during January more than any other month of the year
What is the January Effect?
The January effect is a recognized increase in the prices of stocks during January more than any other month of the year. This rally makes some investors seek to purchase supplies before January and sell them during the time of increase.
If this hypothesis is accurate, it would claim that the market is inefficient since an efficient market would eliminate such effects.
The effect was first noticed in 1942 by investment banker Sidney B. Wachtel. He saw that since 1925 small stocks outperformed the rest of the market, with most of the gap appearing during the first half of the month.
What makes this theory even more insane is that when linked with the US presidential cycle, the most noticed increase in stock prices usually happens during the third year of the cycle.
Plenty of explanations have been presented by different experts regarding this theoretical effect. Economists believe this effect may occur due to the increase in buying during January.
This increase in buying is typical because investors, who are engaging in tax-loss harvesting to reduce their capital gains, begin selling their stocks in December, which causes a drop in price during this month.
These investors, known to be tax-sensitive, usually attempt to realize capital losses to minimize the amount of taxes paid at the end of the year and re-invest at the beginning of the new one.
Another possible explanation for this effect is that investors may use their year-end bonuses to purchase investments in the coming month.
Note that the January effect does not always occur, as in some cases, small stocks underperformed the broader market. This underperformance was observed in 1982, 1987, 1989, and 1990.
Key Takeaways
- The January effect is a realized increase in the prices of stocks during the month.
- It occurs when investors sell their stocks in December to reduce their tax bills.
- It contradicts the concept of an efficient market. This contradiction is why many critics have denied its existence.
- There are not enough economic fundamentals supporting the existence of the January effect. Thus, making financial decisions based on the impact may not be the wisest decision.
- Even if the effect seemed to be happening in the past, it is impossible to continue in the future as it is now only based on individual investors, accounting for a small portion of the market. Thus, they don't have the influence to affect the market.
- Investors should follow a systemic and organized strategy, emphasizing the time of the market rather than timing the market while also seeking financial advice.
Drivers Behind the January Effect
Various probable reasons have been discussed to explain the January effect:
1. Tax-loss harvesting
With tax-loss harvesting, investors sell some of their investments at a loss to neutralize gains realized by selling stocks at a profit. This loss allows investors to only pay taxes on their net profit, effectively deducting the losses from the profits and reducing their tax bills.
Investors usually use this strategy at the end of the year by selling some of their stocks in December, reducing the price of the stocks they sold, and then repurchasing other stocks in January, increasing their prices during the month.
2. Year-end bonuses
A year-end bonus, also known as a Christmas bonus, is a monetary reward paid to an employee at the end of the year. These bonuses depend on performance metrics and goals achieved.
Year-end bonuses could also explain the increase in stock prices in January, as many investors would use their rewards to purchase stocks during the month. With the increased demand for stocks during the month, their value increases.
3. Psychological factors
Many investors reflect on their previous years' financial status and strategies. That's why they may decide to change their investment strategies by buying stocks during January, maybe as part of a new year's resolution.
4. Window dressing
One of the most reasonable explanations is "window dressing." This concept states that as the year-end proceeds, professional money managers start getting rid of stocks that don't look desirable when they submit reports to clients.
They replace these stocks with more desirable ones that make them look better. This action drives prices down during December and pushes them back up during January when the pressure ceases.
Does the January effect exist?
If it was true, why wouldn't investors wait until January each year and begin selling their stocks when prices rise? Investors aren't idiots, and this theory is too good to be true as it does not have financial fundamentals backing it up.
Assuming the effect is true, investors can buy stocks during December, anticipating higher returns during January. This action would drive up prices during December, bringing forward the expected increase from January.
This increase in December would ultimately eliminate the January effect and create the "December Effect," moving back month by month in a cycle of anticipation. This incident describes an efficient market where such opportunities would be eliminated.
Another obstacle in the way of this theoretical effect is that each possible explanation has a missing piece to prove the actual existence of the impact.
Regarding tax-harvesting, the US tax reform act of 1986 implies mutual funds to issue 98% of their capital gains generated in 12 months by October 31st.
Indicating that the ending period for mutual funds to realize capital gains is October 31st rather than December 31st.
This ending period means that any mutual fund's tax-motivated selling should happen by October 31st rather than the end of the year.
For the tax-harvesting explanation to become true, professional money managers can't be behind it. Individual investors would be.
However, individual investors own a minor part of the stock market today than they used to.
The numbers aren't significant enough to influence the market. For instance, in the UK, they are 14%, in Japan, 17%, and in the US, they are 36%. Their piece of the cake isn't big enough to directly impact the whole market.
It is also worth noting that UK and Australia do not even have December tax-year ends. Australia is June 30th, and the UK is April 5th. These periods conclude that the tax-harvesting explanation does not hold up in these markets.
The window dressing explanation includes selling undesirable stocks and replacing them with better-looking ones. This replacement puts pressure on both buying and selling. Investors anticipate their rebound during the following month when they sell the stocks.
However, the pressure is also on the desirable stocks being bought since the results anticipated could be negatively inverted in January, proving this explanation can't quite hold up.
Nevertheless, it also gives investors less credit for their work, neglecting weak performances if the names on the report were desirable.
Additionally, passive funds would not want to be part of this since they only target matching the returns and compositions of a benchmark index.
With the growing numbers of passive ownership, even if the effect was confirmed in the past, it can't be in the present or future.
Conclusion
Statistics can be tricky and may convince people of theories and illusions that are just too good to be true. If you look at the numbers, the January effect seems true, but in fact, there is no real economic or financial reason behind the existence of such an effect.
If something usually happens without an apparent reason, then there is no guarantee that it will continue to happen. That's why timing the market and waiting for January to pull your investment tricks may not be the best idea.
Even if this effect is actual (it's not), the market rise during the month will make people exploit the opportunity, diminishing its existence.
Some researchers claim that the January effect still exists, but only for small-cap markets, due to investors' lack of liquidity and interest.
In summary, investors can't rely on timing the market and waiting for an effect that can't be predicted.
Investors should invest in a more systematic and organized way, emphasizing the time of the market rather than timing the market, and seek financial experts' advice when making an investment decision.
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