The January Effect is a historical trend where the stock market falls in December and recovers in January, with smaller companies recovering faster than larger ones. Shareholders sell stocks before the end of December to avoid capital gains taxes, leading to a temporary increase in January. However, the phenomenon is now considered more of a historical anomaly than a profitable trend.
The term January Effect refers to a tendency for the stock market to fall sharply at the end of December, only to recover significantly during the first few weeks of January. Historically, smaller companies have shown much faster recovery than larger companies during this time period. Investment professionals refer to stocks in smaller companies as small-caps, and larger companies as mid-caps or large-caps. The January Effect applies primarily to small- and mid-cap stocks, because large-cap stocks rarely sell in December and are generally more stable.
Shareholders regularly face special taxes called capital gains taxes. This tax is largely based on the shareholder’s financial statement at the end of December. For this reason, many small-cap shareholders are looking for ways to avoid being taxed on unperforming stocks. If shareholders can sell these shares before the next year starts, their capital gains taxes should be lower. Historically, this has led to a large amount of sales during the last week of December.
In the 1980s, savvy investment brokers noticed this December sell-off trend and began to study its consequences. They discovered that many shareholders were buying back their shares during the first weeks of January, creating a temporary but significant increase. If other investors bought available small-cap stocks in December, they could also benefit from this increase in late January. Thus, the January Effect became a buzzword among investors. Smaller companies almost always outperformed larger companies during January, so buying and selling high became much easier to predict.
Some believe that the January Effect is now more of a historical anomaly than an ongoing profitable phenomenon. Small-cap stocks haven’t always outperformed large-cap stocks during January, and many shareholders can now shield themselves from capital gains taxes through retirement accounts. It is no longer necessary to sell stocks before tax season begins. The stock market itself has also adjusted for the January effect, with fewer small-cap stocks soaring noticeably in early January.
The January Effect has taken the world of stocks and bonds by storm. Businesses can reduce inventory or the number of employees in December to reduce tax liabilities, only to rehire and restock in early January. Retailers often experience a reverse January effect, as sales drop significantly after the holiday shopping season.
Belief in the January Effect varies widely from broker to broker. Some still anticipate short-term gains from judicious investment in volatile small-cap stocks, while others see the January Effect as a relic of the aggressive investing philosophy of the 1980s and 1990s.
Smart Asset.
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