The January effect is a trend where the stock market falls in late December and rebounds in January, with smaller companies recovering faster than larger ones. Shareholders try to avoid capital gains tax by selling unprofitable stocks before the end of December, leading to a sales binge. Experienced brokers noticed this trend and found that buying small-cap stocks in December and selling them in January could lead to profits. However, the January effect is now seen as more of a historical anomaly, and belief in it varies among brokers.
The term January effect refers to a tendency for the stock market to fall sharply in late December, then rebound significantly during the first few weeks of January. Historically, smaller companies have shown a much faster recovery than larger companies during this time period. Investment professionals refer to the shares of smaller companies as small-cap and the shares of larger companies as mid- or large-cap. The January effect mostly applies to small- and mid-cap stocks, because large-cap stocks are rarely sold in December and are generally more stable.
Shareholders regularly face a special taxation called a capital gains tax. This fee is largely based on the shareholder’s financial condition at the end of December. For this reason, many small-cap shareholders look for ways to avoid being taxed on unprofitable stocks. If shareholders can sell these shares before the start of the following year, their capital gains taxes should be lower. This has historically led to a massive sales binge during the last week of December.
In the 1980s, experienced investment brokers noticed this December sell-off trend and began studying its consequences. They found that many shareholders were buying back their shares during the first few weeks of January, creating a temporary but significant spike. If other investors buy small-cap stocks that are available in December, they could also profit from this peak by the end of January. So the January effect has become a buzzword among investors. Smaller companies almost always outperformed larger companies during the month of January, so buying low and selling high became much easier to predict.
There are those who 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 in January, and many shareholders can now protect themselves from capital gains taxes through retirement accounts. You no longer need to sell your stock before tax season starts. The stock market itself also adjusted for January’s effect, with fewer small-cap stocks posting a notable increase in early January.
The January effect has overtaken the world of stocks and bonds. Companies may reduce inventory or headcount in December to reduce tax obligations, 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 expect short-term gains from judicious investments 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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