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The January Effect

The January Effect refers to a possible pattern or phenomenon that stocks exhibit, in particular small-cap, whereby the tendency is a rise during the last several trading days in December and then a continued rally throughout the first week of January. This rally is generally attributed to an increase in buying, which follows the drop in price that typically happens in December when investors, seeking to create tax losses to offset capital gains, prompt a sell-off. Once the New Year rolls around, they buy back the same stock, pushing up prices.

The Concept has been widely debated for decades, and recent research has shown that if the effect offers any trading edge at all, it is slight and short lived. This article aims to offer the trader and investor an explanation of where the hype comes from and why it matters.

So how does it work?

A number of theories try to explain the reasoning for the rally in stock prices in January. The most obvious being the practice of “Window Dressing”. This idea holds whereby Mutual Fund managers will go “shopping” at the end of December to buy stocks that greatly appreciated during the year. The listing of these stocks in the fund’s annual report would look good to the shareholders, whereby the portfolio is “dressed up” to contain a few extra valued stocks. The prices of the stronger stocks rally even further due to the high demand, hence the rally in January.

Conversely, the opposite holds for weaker stocks that year, where again, as the year end approaches many investors and fund managers will look to offload poor performing stocks so as to trim the fat off portfolios and get rid of their ties to bad investments.

Primarily, however, the heavy trading volume is influenced by tax considerations, whereby much of the selling of stocks is done in order to realize capital losses that can be used to offset capital gains elsewhere. As the New Year begins the gains from these sales are more often than not reinvested into the market prompting stocks to rally.

It is often argued, however, that stocks typically rise in January due to trader psychology. The very simple idea that a new year brings new hope, and for some a way to invest in the market some end of year bonuses.

This historical trend, however, has been less pronounces in recent years, some believing the expected rally has already been priced into the market, and has adjusted for it. Tax-sheltered retirement plans have also grown in popularity, ending the need for many investors to sell and rebuy stocks for tax reasons.