Every January a few things happen. Mostly they involve enrolling at, fighting for space in, then giving up on a gym. That’s okay. We completely understand that January is a tough month for getting back in shape.
Try heading back in February. There’ll be less competition for the treadmill and you’ll still have plenty of time before beach season.
While the rest of us worry about dropping a few pounds, eating healthier or finally finishing that novel (yours truly, for those interested), investors have another goal in mind. They spend December and January of every year with one thing on their minds: taxes. On December 31 one tax year ends, and on January 1 another one begins. That simple rule has led to a market-wide theory called the January Effect.
Here’s what you need to know.
What Is the January Effect?
The January Effect is a theory which says that every December stock prices take a dip and every January they receive a boost. This is driven by heavy selling during December and aggressive buying during January, particularly early in the month. Investors tend to sell off low-performing stocks at the end of each year. They then tend to buy those stocks back a few weeks or even days later.
What Causes the January Effect?
The January Effect is driven by tax planning. Investors sell off stocks at a loss before the end of each year to try and mitigate their upcoming capital gains taxes. Once the calendar rolls over, they buy those stocks back to hold for another year of (hopeful) gains.
Investors are taxed on their collective capital gains over the course of every year, measured from January 1 to December 31. The important thing about this is the word “collective.” An investor pays taxes on the total results of all their investment income. So, say an investor owns stock in Company A, Company B and Company C. They then sell off all three bundles of stock at the same time for the following results:
- Company A - $10,000 Profit
- Company B - $5,000 Profit
- Company C - $7,000 Loss
In this example, our investor’s taxable investment income would be $8,000. They would have made $15,000 from the first two investments, but they could write off the losses from Company C.
So, in an effort to minimize their tax bill as much as possible, investors will sell off assets that have taken a loss before the end of the year. But this doesn’t mean the investors don’t want those stocks. In our example above, the investor may believe that Company C is poised for long term growth. So the investor will sell the stock off right before December 31, cutting their taxable investment income almost in half. Then they might buy it right back up in January, to sit and wait for that growth.
The January Effect mostly impacts small-cap stocks. These are less liquid than mid- or large-cap assets. When investors sell off larger stocks the market tends to react quickly. If a pool of investors dump Apple (AAPL) - Get Apple Inc. Report shares, even a small fluctuation in that company’s stock price will bring in new buyers. It can take hours, not weeks, for the market to react when a large-cap stock fluctuates. Smaller stocks tend to take longer to attract new buyers, and as a result their prices tend to take longer to bounce back.
Is the January Effect Real?
The January Effect is hotly debated.
Calendar-based fluctuations are a sign of an inefficient market. They involve people buying and selling stocks not based on the value of the underlying company but because of external concerns. (In this case, to game the tax code.)
Efficient market theorists argue that modern markets work too efficiently for the January Effect to significantly affect trading any longer. Investors would anticipate this effect and would buy stocks as other investors offloaded them in December, anticipating the rise in January, or would price this into their trades up front.
The truth seems to be somewhere in the middle. The January Effect no longer appears as pronounced as it was in the mid-20th century, when it was first documented. However some data still supports the idea of a December/January fluctuation to a certain degree. Just as one example, in 2019/2020 the Dow Jones Industrial Average fluctuated from 28,645.26 on December 27 to 28,462.14 on December 30 back to 26,868.80 on January 2. This is a small margin of movement, all within approximately 400 points, but it obeys the rules that the January Effect tells us to expect.