What is the January Effect?

The term January Effect refers to a tendency for the stock market to dip sharply at the end of December, only to rebound significantly during the first weeks of January. Historically, smaller companies have shown much faster recovery than larger companies during this time period. Investment professionals refer to smaller company stocks as small-caps, and larger company stocks as mid-caps or large-caps. The January Effect applies mainly to small-cap or mid-cap stocks, because large-cap stocks are rarely sold off in December and generally more stable.

Stockholders regularly face special taxation called a capital gains tax. This tax is based largely on the stockholder's financial state at the end of December. For this reason, many small-cap stockholders look for ways to avoid being taxed on non-profitable stocks. If stockholders can sell off these shares before the following year begins, their capital gains taxes should be lower. This has historically led to a massive selling binge during the last week of December.

In the 1980s, savvy investment brokers noticed this December sell-off trend and began to study its aftermath. They discovered that many stockholders were buying back their shares during the first weeks in January, creating a temporary but significant spike. If other investors bought available small-cap shares in December, they could also profit from this spike by the end of January. Thus the January Effect became a buzzword among investors. Smaller companies almost always outperformed larger companies during January, so buying low and selling high became much easier to predict.

There are those who believe the January Effect is now more of a historical anomaly rather than an ongoing profitable phenomenon. Small-cap stocks have not always outperformed large-cap stocks during January, and many stockholders can now protect themselves from capital gains taxes through retirement accounts. There is no longer the need to sell off stocks before tax season begins. The stock market itself has also adjusted for the January Effect, with fewer small cap stocks spiking noticeably in early January.

The January Effect has moved past the world of stocks and bonds. Companies may reduce inventory or the number of employees in December in order to reduce tax obligations, only to rehire and restock in early January. Retailers often experience a reversed January Effect, as sales dip significantly after the holiday shopping season.

Belief in the January Effect varies widely from broker to broker. Some still anticipate short term gains from judicious investment in volatile small-cap stocks, while other see the January Effect as a relic of the aggressive investment philosophy of the 1980s and 1990s.