Every January, while the most of us worry about shedding a few pounds, eating healthier or finally reading those novels we have been putting off, investors ponder upon whether the January Effect will be seen this year or not.
While the stock market is known for its volatility, market anomalies are also often found. Market anomalies are distortions in returns, contradicting the Efficient Market Hypothesis (EMH). According to the EMH, it is impossible for investors to sell overvalued stocks or purchase undervalued stock as stocks always trade at their fair value. However, one widely accepted market anomaly is the January Effect.
What Is the January Effect?
The ones who follow the market on a regular basis might have witnessed a slight rise in share prices at the very beginning of the year. This is the January Effect. The January Effect is a hypothesis that there's a seasonal cycle in the financial market where stock prices rise more in January as compared to the other months. There's heavy selling in December and aggressive buying in January, specifically early in the month. The January Effect was first noticed by Sidney Wachtel, who was an investment banker, in 1942. Looking at data from 1925 onwards, he saw that small-cap stocks had outperformed the market in most Januaries. (The January Effect appears to affect small-cap companies more than mid- or large-cap companies due to their lower liquidity).
What Causes the January Effect?
Since the idea first emerged, a lot has been researched and debated upon as to what causes this effect to take place. Researchers have attributed this to a number of reasons:
Tax Deduction: Taxes in the United States are due to be paid on 31st December of every year. The most common theory explaining this phenomenon is that individual investors, who are income tax-sensitive and who disproportionately hold small stocks, sell stocks for tax reasons at the year-end (such as to claim a capital loss) and reinvest after the first of the year. A capital loss is the result of selling an investment at less than the purchase price or adjusted basis. Any expenses from the sale are deducted from the proceeds and added to the loss. The key point is that capital losses are only losses after you sell them. This is one of the best deductions available to investors. A capital loss directly reduces your taxable income, which means you pay less tax.
Portfolio Dressing: A lot of people let investing to be done by the experts in the form of mutual funds and other portfolio managers. A strategy used by mutual fund and portfolio managers near the year-end to improve the appearance of the portfolio/fund performance before presenting it to clients or shareholders is window dressing. The fund manager sells stocks with large losses and purchases high flying stocks near the end of the year to create a good impression. They later buy the same stocks in January if they believe that it might have a good year ahead after a poor previous year.
Individual Behavior: There are behavioral reasons why it may exist. As the new year marks a new beginning and brings positivity in the markets, many people start investing in the new year or open new positions simply because they feel that the new year marks a great time to start. In fact, data shows that trading volumes are particularly high in the first few days of January. Instead of adopting new resolutions, they buy new stocks.
Increased Income: The income that the investors earn by selling their stocks at the end of December coupled with hefty Christmas and year-end bonuses increases the spending power of investors. This excessive cash is then used to purchase stocks, creating demand, and driving prices up.
The stock market in January 2021:
The January Effect came early in 2020. Amid the COVID-19 pandemic, the US stock market ended 2020, with an all-time high on the last day of the year. In 2020, the S&P 500 and the Nasdaq Composite gained 16.3 per cent and 44 per cent. However, January 2021 has been a rocky ride due to rising coronavirus infections and deaths nationwide. The month started with the U.S. Senate runoff election in Georgia, which provided additional market volatility. However same wasn’t the case for India which saw Sensex reach a high of 50,184.01 on January 21, 2021.
There is another chunk of the population that does not believe in the January Effect and give counterpoints for the above reasons.
Since the effect is known for almost 80 years now and studied a lot in the past, every investor is well aware of it. In such a scenario, lots of investors would buy in December rather than January, in anticipation of strong January returns. This would drive up prices into the year-end, bringing forward some of the performance that would have been anticipated for January. January’s returns would be lower as a result and the January effect would cease to exist. The fact that this doesn’t happen portrays that it’s not all easy money.
In regards to window dressing, the US Tax Reform Act of 1986 requires mutual funds to distribute at least 98% of realized capital gains and dividend income generated during the 12-month period ending 31 October. The implication is that, since 1986, any tax-motivated selling by mutual fund managers should occur well before 31 December. It can’t be part of the explanation. For the tax management explanation to hold, individual investors must be behind it, not professional money managers. But individual investors today directly own a much smaller share of the stock market than in the past.
Apart from this, there are very limited countries which have December tax-year ends. For India it ends on 31st March, for the U.K. it ends on 5th April, and therefore in such nations, tax management cannot explain the presence of the January effect in the markets.
As window dressing involves selling some undesirable stocks and replacing them with ones which would look better in a report, it involves both buying and selling pressure on the market. To the extent that it pushes down the price of the stocks being sold, resulting in an eventual rebound in January, it must also put upward pressure on those stocks being bought, exposing them to the risk of a negative reversal in January. Hence, this reason is disregarded by many.
When we compile the data of the past 93 years from 1928 to 2020, the S&P 500 (Stock Index) rose 62% of the time in January i.e. 58 out of 93 times. While several studies have pointed out that returns in January are larger than the returns throughout the year, some have pointed out that this effect is diminishing in recent times.
If we were to conclude whether the effect still exists, we understand the reality lies somewhere in the middle. While this was very prominent in the 20th Century, it no longer is as pronounced now. The rule held true in 2018 and 2017, but the market fell in 2016. Market anomalies are generally traded away and should not exist in an efficient market, but one can also not ignore the statistical figures indicating a significant pattern across the years.