What is the ‘January Effect’ and Why Does it Happen?

Market cycles and seasonality are important concepts in the financial market. Seasonality refers to a certain belief that the stock market rises or falls in certain periods.

Cycles, on the other hand, is the belief that the equity market performs in a certain way after it goes through a certain condition. For example, it tends to rally after going through a substantial dip.

In this article, we will look at the January Effect, which is a type of seasonality.

What is the January Effect?

The January Effect is the idea that stocks, especially the S&P 500 index, usually rise in January. Investors believe that stocks bounce back in January after experiencing a dip in the final week of December.

The idea is that stocks usually rise in the run-up to Christmas, in what is known as the Santa Rally. After that, traders usually start selling their holdings before December 31st in their bid to do what is known as tax-loss harvesting.

For starters, tax-loss harvesting is the process of selling stocks in a bid to lower your overall costs. For example, if you own a basket of stocks, some will make a profit while others will make a loss.

In tax-loss harvesting, you can sell the stocks that made a loss and then you use that loss to offset your capital gains tax. Finally, you can use this money to invest in other stocks that are bound to rise.

Subsequently, some stocks will generally drop in December and then start bouncing back in January due to this harvesting.

Other Reasons Why the January Effect Happens

Another reason why the January effect happens is that many portfolio managers use the month to reset their holdings. For example, if you are a fund manager, you will mostly measure your performance per-annum. Therefore, in the final week of December, you can sell all your holdings and then start afresh in the new year. This will possibly see you buy new stocks during this period.

Similar to this, some long-term investors use the concept of periodic arbitrage in their investments. In this, they attempt to buy the laggards stocks in the previous year hoping that they will rebound. As a result, it is an often occurrence for these stocks to bounce back.

The January effect also usually happens because of the enthusiasm among the investing community about the coming year. In this, if the stocks had a great year, they hope that the trend will continue. However, if they had a bad year, they hope that they will go through a rebound.

How to spot trend early!

Finally, many people form New Year’s resolutions. The most common resolution is usually related to weight gain and weight loss. Also, a common goal for most people is on financial health. Some plan to invest in the financial market, which leads to higher stock prices.

Example of the January effect

2020 forms an excellent example of the January effect at work. Before the year started, most global indices dropped slightly as traders took their profits. But in the first week of the year, global stocks bounced back, as shown below.

In total, the S&P 500, Nasdaq 100, FTSE 100, and Dow Jones rose by more than 3%, making it the best start of the year in years. This upswing was due to the increasing hopes of a bigger stimulus package in the United States.

indexes end of 2020

Indexes end of 2020. Chart from Tradingview

A bigger example of leverage is shown in the longer-term chart shown below. As you can see, the S&P 500, which tracks the biggest 500 companies in the United States, rose in January 2017, 2018, and 2019. However, it dropped in 2020, in part because of the confusion about the coronavirus cases and the trade war between China and the United States.

The January Effect on Dow. Chart from Tradingview

Does the January effect work?

There have been multiple studies about the efficacy of the January effect in the financial market. Some authors have noted that stocks generally rise during this period. A good study is shown in the chart below.

However, as you can see, the S&P 500 has actually risen and dropped in equal number of times between 2000 and 2019.

Source photo: DailyFx

Therefore, as a trader, you should not always price-in the January effect in your trading. Instead, you should focus on your original strategy and identify winners and losers.

For example, if you specialise in technical analysis and price action, you should use these strategies to select your assets. Similarly, if you specialise on fundamental analysis and tools like time and sales and level 2, you should use it well.

Final thoughts

The concept of market cycles is often talked a lot in the financial media. You will often hear analysts talk about the Santa rally and the January effect. They are catchy and often make sense.

However, as a day trader, you should think beyond that. This means that you should focus on your trading strategy and avoid such market cycle terms.

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