What is the January Effect?

Posted on December 7, 2010 at 7:28 pm

By: John Darsie of T3Live

The January effect is a term to describe a phenomenon in the financial market where securities prices increase during the month of January, often following a decrease at the end of the previous year. The concept was firstintroduced in 1942 through a paper by Sidney Wachtel. The phenomenon, which effects small cap stocks more than mid and large cap ones, has weakened in recent years, however, due possibly to increased publicity and awareness which the market now prices in.

What causes the January effect?
Several scholarly papers have been written since 1942 suggesting various drivers for the January effect, but there is no definitive evidence of an exact or single cause. Two of the most popular sources on the subject are “The Incredible January Effect: the stock market’s unsolved mystery” by Robert Haugen and Josef Lakonishok (published in 1987), and a 2005 paper from a team at William & Mary. A few of the driving factors often mentioned as causes of the January effect are:

Holiday Psychology: Behavorial finance, as a front in its war on the efficient market hypothesis, attributes the January effect to a rosier, more positive mindset for investors following the festive holiday season. After the Christmas season, individuals are more pre-disposed to invest.
Tax Motivation: Investors might also be motivated to sell losing stocks at the end of the year to offset some capital gains for year-end tax reporting purposes, and then, after the expiration of the 30-day wash rule, buy those securities back.
Shoppers Raising Cash: Investors who need liquidity for holiday shopping might dump securities to raise cash, after which bargain hunters come in during January to scoop up those discounted stocks.
Small Cap Year-End Research Reports: Small cap stocks often release year-end research reports, and some believe these reports make small cap stocks more attractive investments near year-end.

One thing to consider in this market cycle is that there are not many securities that may be sold at a loss this year. The vast majority of investors who can still sell a stock at a loss are those who have been holding stocks for the entire market cycle, and those individuals are less inclined to make impulsive buys or sells. This December, keep an eye on stocks that are down year-to-date. One theory could follow that that these losing stocks could get some selling pressure into year-end as investors looks to off-set capital gains, but then perk up considerably in 2011 as long as strong fundamentals are still in place (see Adobe).

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