What is the January Effect?

The January Effect is a theory based on seasonal increases in stock market share prices that occur in January. With investment professionals looking at data to identify short- and long-term trends, it is a phenomenon most often observed with small-cap stocks, though it can affect a wide range of securities.

"It's all about trying to explain a certain market action that occurs at a certain time of the year," explains Gary Christie, Head of North American Research at Trading Central. "Looking back on 20 years of data, many investors believe that the January Effect is very real, but it's important to remember that the stocks and sectors subject to the January Effect aren't consistent and can change over time."

As some stocks in certain sectors decrease in value at the end of December and then increase in value by the end of January, investors are trying to take advantage of the price dip in the first weeks of January. Indeed, investors attempt to capitalize on this by buying shares at the start of the new year in the hope of seeing gains in the following weeks and months.

How does the January Effect work?

Before focusing on January, it’s important to first understand what happens in December. During this time of year, two key factors come into play:

• 1. Lower trading volumes – As North American investors become distracted by the upcoming holiday season, trading volumes typically drop. This often results in lower volatility, meaning that share prices tend to stabilize and fluctuate less.
• 2. Tax-loss selling - December is also of the time for tax-loss selling, where investors and portfolio managers sell underperforming stocks to generate capital losses, which can offset other capital gains. Tax-loss selling creates downward pressure on some share prices, or it helps prevent prices from increasing.

The stocks most impacted by the January Effect trade lower in the month of December, as they have been candidates for tax-loss selling and have been actively sold off. As a result, they are more likely to find themselves in an oversold position with lower valuations.

In January, once the holiday season is over, investors are eager to return to the markets and start the year of strong. Many repurchase the shares they sold after the 30-day tax-loss selling period in December, which contributes to the upward trend in prices.

The January Effect stems from the perception that stock prices rise at the start of the year more frequently than in other months, driven by these conditions.

What causes the January Effect?

The January Effect is not consistent across all stocks or sectors, and there’s no single and consistent explanation for what causes it. While more cash in investor portfolios is certainly a factor, a variety of other variables contribute to this phenomenon, like many other investment theories.

As mentioned before, one explanation is tax-loss selling, where investors repurchase shares in early January after selling them in December for tax purposes.

The influx of cash that comes from year-end bonuses also plays a role, as this new capital often enters the market at the beginning of the year.

Additionally, many investors make their annual RRSP and TFSA contributions in early January, further boosting the available cash for reinvestment. This combination of factors can create a wave of buying activity, driving stock prices higher.

However, not every stock benefits from the January Effect. The value and performance of a security in the months leading up to December and January are important factors. At the end of the day, not all stocks will be positioned or meet the conditions to benefit from the positive outcomes that the January Effect theory predicts.

Since it's difficult to pinpoint an exact cause, analysts use powerful tools like NBDB's Strategy Builder to help identify stocks that might be good candidates for the January Effect.

Find investment ideas with Strategy Builder

Is the January Effect real?

Do the facts support the January Effect theory? There’s no clear answer. While historical data shows some support for the January Effect, it doesn’t occur consistently every year, and it has diminished significantly as modern markets have evolved.

Here are some important facts to keep in mind:

• The January Effect is typically concentrated in the first 5 to 10 trading days of the month, rather than throughout January. Over the past twenty years, the SPDR S&P 500 Index ETF Trust (SPY) has only closed above its daily starts 50% of the time in January, suggesting no significant long-term advantage.¹
• The Nasdaq has closed higher 60% of the time in January over the past twenty years, possibly due to the popularity of tech stocks.¹
• The Invesco QQQ, a tech and innovation-focused ETF, has closed higher in January over the past five years with an average rate of return of 1.4%.¹

Based on recent data, the Nasdaq index and tech stocks seem to benefit the most from the January Effect, with higher seasonal returns. Additionally, stocks with strong fundamentals but underperforming at year-end present potential January Effect opportunities.

How to predict the January Effect

One of the methods that experienced investors use to determine the likelihood of a January Effect is technical analysis. By identifying key indicators, technical analysis helps investors identify the securities that may experience price increases at the start of the new year.

The role of RSI indicators

Starting with strong fundamentally rated equities, the Relative Strength Index (RSI) is an indicator that can be used to identify the momentum of a specific stock. It can help investors identify stocks that may have been sold off in December due to tax-loss selling, but which could increase in value throughout January and beyond.

• An RSI below 30 indicates a stock is oversold.
• An RSI above 70 suggests a stock is overbought.

Stocks that dip below 30 on the RSI in December and begin to rebound toward the RSI median level of 50 can be considered potential candidates for the January Effect.

Though the January Effect is an interesting phenomenon, it is important to remember that, as Gary Christie from Trading Central points out, it’s driven by "optimism, extra cash, and a fresh start." Timing the market based on this effect, however, is rarely the best strategy, particularly for new and novice investors.

Like any market effect, we can rely on several indicators to make our investment decisions, but the recommended approach is to have an investment plan that includes considered and regular purchases that reduce the risks associated with short-term market effects.

By investing regularly and maintaining a long-term investment horizon, self-directed investors can weather market ups and downs with confidence. Remember that investing comes with risks, so be sure to do your research and invest thoughtfully to make informed financial decisions.