What is the January Effect?

It’s a new year! Typically January sees great rises in stock price that sets out the success of markets for the year ahead. Will we see markets rise this month, considering the heavy economic burden of the pandemic? Read on to understand more. 

What is the January Effect?

It is a seasonal phenomenon where stock prices increase. There are many explanations for it but it occurs mainly due to increased buying and then a price drop in December. This end of year price drop occurs when investors sell off to achieve year end capital gains taxes and use year end cash bonuses to start them off in the new year. There is a pattern of selling off stocks that carry heavy capital losses before the new year rolls in and then buying stocks with capital gains in January. Year end selling also encourages buyers who spot the low prices, knowing that the price fall is more about markets than poor company performance. With many buyers being active, this can help push prices up in January. Another contributor is investor psychology, with more people starting investing as a New Year’s resolution driving prices up. As more investors tend to be active right after New Years this can drive up stocks almost straight away!

January is bonus time and what do people tend to do with it? Invest it of course!

The January Effect, along with all seasonal effects demonstrate the markets are inefficient. It affects small caps the most as these are most liquid. In January, these asset classes outperformed the overall market that month, although the historical trend has been less obvious recently due to greater market adjustment. It has also become less prominent since in 2018 as people are using tax-sheltered retirement plans and therefore don’t need to sell at the year end for a tax loss. 

Although this doesn’t happen every year, since the 1920’s the S&P 500 rose 62% of the time in January at an average of 1.2%. January is also on record for seeing the biggest stock and bond inflows. Although this good chance of stock rises seems extraordinary, the truth is that in general the stock market rises 60% of all years following economic growth. But this does mean that seeing a stock market rise is a good indicator on how it will perform over that year, with a strong correlation between January increases and yearly increases found to date. 

What happened last year?

The S&P 500 rose 1.1% and the Dow Jones Industrial Average was up 1% already in January 2020, whereas NASDAQ rose 2.3%. With geopolitical tension and the start of the pandemic looming the markets rose much less than January of the previous year (2019), which saw 7.9% gains. Will this year see the start of recovery or the continuation of the recession induced by the pandemic? Only time can tell. With a weak economy over 2020 there isn’t great hope that we will see the January Effect happen. 

What should I do?

Ask yourself what strategy you follow. If you trade on the short-term then paying attention to the January Effect is essential to harness profits, whereas if you invest long-term, changing up your strategy for this seasonal phenomenon will leave you clueless and out of your depths.

If you’re a long-term player it is best to invest consistently. It can be tempted to hop on board with the January Effect but stick to your guns. Follow your predetermined strategy that lets you profit from your particular skills. If you usually invest regularly, it would be best to ignore this month-long phenomenon as you already ignore the small fluctuations in markets. Long-term investments can reliability yield on average 10% return, so don’t change what works for you!

The January Effect can see price rises across markets, irrespective of company performance making it the prime time to buy. Will we see this happen this year or will the pandemic led recession stop markets from rising? Keep up to date with the latest stock market news with BullBear.