With 2018 just around the corner, it’s time to start looking ahead to the “January effect.” The January effect is one of a number of seasonal trading trends that have become popular over the years. Here’s all you need to know about how it works.
According to the theory, the January effect is a name for the stock market’s relatively strong performance at the beginning of the year. In addition to general optimism associated with the start of a new year, the January effect is supposedly triggered by stock buying following year-end tax-loss selling in December.
This happens because many people want to buy back stocks that they sold at the end of the year. However, you must wait 30 days to repurchase any stock sold in December for tax-loss purposes. As a result, many of these stocks will see heavy buying toward the end of the month of January.
According to data from Yardeni Research, the January effect theory holds a bit of water, but only to an extent. From 1928 to 2017, the S&P 500 has been relatively strong in the month of January, averaging a 1.1 percent annual gain. However, the month of December, which includes the tax-loss selling that is often cited as the reason for the January effect, is one of only two months (along with September) in which the S&P 500 has historically performed even better than January. In fact, since 1928, the S&P 500 has averaged a 1.4 percent annual gain in December.
According to a 2017, Goldman Sachs study revealed that the January effect has disappeared altogether. Since 1999, Goldman found that stocks have averaged a 0.5 percent decline in January compared to an average 0.2 percent overall gain in all other months.
Another study by Salomon Smith Barney found that small-cap stocks may be impacted more by the January effect than others. From 1972 to 2002, the Russell 2000 index outperformed the Russell 1000 index by 0.82 percent in January.
Seasonal trading trends such as the January effect often tend to get weaker or even disappear over time as more traders learn about the trend. Ironically, this trading eventually weakens and then eliminates the original trend altogether.
One less popular (and potentially more effective) trading strategy for the month of January may be buying European stocks following years of outperformance by U.S. stocks. U.S. investors who rebalance portfolios geographically may be looking to buy European stocks after a strong year for the U.S. market. Goldman found that the STOXX 600 has gained an average of 1.5 percent since 1974, and the S&P 500 is historically more likely to underperform the STOXX 600 in January than in any other month.
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