While we desperately wait optimistically for a new year to filter out our negativity, complete the broad list of lifestyle changes and finally stick to New Year Resolutions, investors ponder upon whether the January Effect will hold true this year or not. While the stock market is known for its unpredictability, market anomalies are often detected. Market anomalies are distortion in returns contradicting the Efficient Market Hypothesis (EMH). According to the EMH, it is impossible for investors to sell overvalued stocks or purchase undervalued stock as stocks always trade at their fair value. However, one such widely accepted market anomaly is the January Effect.

The ones keeping an eye on stocks on a regular basis might have observed that a slight bounce is usually observed at the very beginning of the year. This is the January Effect. In theory, it states that the value of stocks decline every December and increase every January. This effect was initially noted by an Investment Banker, Sidney B. Wachtel in 1942. He observed that small-cap stocks outperformed that mid-cap and large-cap stocks in the month of January since 1925. When investors sell large-cap stocks, they are immediately bought by other willing investors. Hence this effect doesn’t hold true for large-cap stocks. Small-cap is a term used to denote companies with relatively smaller market capitalization. Small-cap stocks are less liquid and while these can offer better financial returns, they are subject to larger investment risk. 

Since the idea first emerged, a lot has been studied and debated upon as to why this effect takes place. Researchers have attributed this to a number of reasons:

  1. Offsetting Capital Gains: Taxes in the United States is due to be paid on 31st December of every year. Capital gain taxes need to be paid by investors on the profit earned on the sale of certain assets. However, capital losses can mitigate capital gain taxes. Let us assume that an investor purchased stocks worth $1000 and $500 during the year. She/he earned 5% i.e. $50 on the former and lost 5% i.e. $25 on the latter. In such a scenario, the investor can sell the latter and is then liable to pay tax only on the net capital gain i.e. $25. Hence, investors at the end of the year sell-off low performing stocks to reduce their capital gain, ultimately less taxed and then tend to buy the same stocks a few days later hopeful of profit in the coming year. Buying stocks creates demand and drives prices up. This strategy holds true as investors are taxed on collective capital gains over the year.
  2. Window Dressing:  A lot of people let investing to be done by the experts in the form of mutual funds and other portfolio managers. However, despite having field knowledge, no one can predict the future. Window dressing refers to a practice by mutual fund and other portfolio managers whereby they eliminate stocks with large losses at the end of the year to create a good impression on investors in their reports. They later buy the same stocks in January if they believe that it might have a good year ahead after a poor previous year.

  3. Bonuses: Hefty Christmas and year-end bonuses are common during December. This increases the availability of cash with investors. This excessive cash is then used to purchase stocks, creating demand, and driving prices up.

  4. Investor Psychology: Some investors believe that January is the best month to do a new investment. The new year marks a new start leaving the past behind and bringing positivity in the market. This positive psychology creates demand for stocks. 

However, there is another side of the population that does not believe in the January Effect and give counterpoints for the above reasons.

Since the effect is known for almost 80 years now and studied a lot in the past, every investor is well aware of it. In such a scenario, it might seem practical that every investor can eye small-cap stocks especially the ones with losses in the past 12 months in December, and then resell it in January. However, if this is the case, stock prices are to increase in December and not in January. Returns of January will be lower as a result and no such effect would exist. 

The US Tax Reform Act of 1986 requires mutual funds to distribute capital gains during the period ending on 31st October and not 31st December. Hence, selling based on tax motive by mutual fund managers ought to take place before November and not January. Therefore, it can be inferred that individual investors are behind the January effect. However, individual investors, today hold a limited portion of the market and it is impractical for them to contribute to such a fall and rise in stock prices. Adding to this, not every country has a fiscal year ended on 31st December. While for India it ends on 31st March, for the U.K. it ends on 5th April. Therefore there is no tax-driven motive for investors to sell stock in December in such countries.

Since window dressing involves selling undesirable stocks, in certain cases it also involves buying of desirable stocks at the same time. Since the undesirable stocks rebound in January, it must also put pressure on the desirable stocks for negative results in January. Further, it is unlikely that window dressing impacts small-cap stocks as buying and selling would primarily affect large-cap stocks. Hence, this reason is disregarded by many.

When we compile the data of the past 93 years from 1928 to 2020, the S&P 500 (Stock Index) rose 62% of the time in January i.e. 58 out of 93 times. In recent years, the January Effect was nominal and the transaction costs made it almost impossible to trade this anomaly and remain profitable. While several studies have pointed out that returns in January are larger than the returns throughout the year, some have pointed out that this effect is diminishing in recent times.

If we were to conclude whether the effect still exists, we understand the reality of its existence lies somewhere in the middle. While this was very prominent in the 20th Century it no longer is as pronounced as it was. January effect can be exploited but there is no confirmation as to whether it will hold true or not. The rule held true in 2018 and 2017, but the market fell in 2016. Market anomalies are generally traded away and should not exist in an efficient market. However, past records prove that this market anomaly held true most of the time.

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