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

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

january effect in markets

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 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.

Related » How to spot trends 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 financial health. Some plan to invest in the financial market, which leads to higher stock prices.

How to prepare for the January effect

The January effect is a concept that tends to sound very good on paper and in theory. However, in most cases, it does not work well as advertised. Therefore, instead of preparing for major movements in January, we recommend that you stick to your trading plan.

There are a few things you can do about this. First, if you are a day trader, always focus on the pre-market movers. In most cases, these are stocks that tend to have more volume and volatility during the trading session.

Second, always stick to your trading plan and strategy. Some of the top strategies that most people use are:

  • Scalping
  • Trend-following
  • Reversals
  • Copy trading

If you use these approaches, you should simply stick to them. 

Third, as a day trader, never try to time the market. Historically, people who attempt to time the market rarely succeed. In this case, you should always work to find trading opportunities in the market and implement them. 

These approaches will help you when trading the January effect and other seasonal events such as during the Summer, Halloween, and even during the so-called Santa Claus Rally.

Examples of the January effect

A good example of the January effect is what happened in 2023. After US stocks plunged in 2022 as the Federal Reserve hiked interest rates, stocks started the year well.

The S&P 500 index jumped from $3,767 in January to a high of $4,195 in February. It then pulled back in February, in a classic sign of the January effect. 

The January effect does not work in stocks alone. It works in other assets like cryptocurrencies. In most cases, cryptocurrencies tend to rally sharply in January and then pull back in the following month. 

As shown below, we see that Solana price was under intense pressure in December 2022 after FTX and Alameda Research collapsed. But in January, the crypto bounced back and jumped by more than 240%. It then retreated as the rally lost steam.

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

The psychology behind the January effect

There are a few moving parts when you are considering the January effect. The first part is known as how people start the year in an enthusiastic manner. One way this is seen is through gym memberships. Most gyms see more users in January because of the New Year’s resolutions. 

The same is true with the financial market. In this case, many people want to start the year in a solid manner. As a result, they tend to buy stocks and other assets, which pushes their prices higher. 

The other psychological aspect is that people tend to be hopeful that the new year will be better than the former one. This explains why they tend to buy assets, hoping that the new year will do well.

Further, the January effect also happens because of tax-loss harvesting. This is a situation where people sell losing stocks towards the end of the year to take advantage of taxes. They then buy them back in the new year, which explains why many losing stocks tend to do well in the new year.

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.

External useful resources

  • History of the January Effect – The Fool
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