The January Effect Explained

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Includes: DIA, IJH, IWM, QQQ, SPY
by: Michael Carr

One of the few universal truths on Wall Street that we are aware of is that “to know what everyone knows, is to know nothing.” In other words, if it really was easy to make money in the markets, then everyone would be a millionaire by now. And, since only about 9 percent of U.S. households report a net worth of at least $1 million (according to TNS, a marketing research firm), there are many stock market investors who are not millionaires.

The January Effect is the widespread belief that stocks tend to rise during the first month of the year, and in particular during the first week. The most popular theory for why this happens is that many investors choose to sell losing positions at the end of the year so they can claim a capital loss for tax purposes. In January, these cash-rich investors try to put their money back to work in the market, causing stock prices to rise.

This phenomena has been widely studied. (See, for example, Mark Haug and Mark Hirschey (2006). "The January Effect." Financial Analysts Journal, 62:5, 78-88.) It has been documented that since 1802, stocks have a tendency to move higher in January. The research concludes that small cap stocks are the best performers, and simply reviewing the academic literature could lead us to buy an ETF such as the iShares Russell 2000 Index (NYSEARCA:IWM) and hope for a profit.

We find academic research is best used as a starting point for investing ideas. To begin finding an investable idea, we wanted to know how often the first week of the year is higher for the various stock indexes. Using all available data, the results are summarized in Table 1.

Index

Percent of time first week of year closes higher

Percentage of all weeks closing higher

Nasdaq Composite
66.7%
56.5%
S&P 500
56.8%
55.7%
Dow Jones Industrial Average
54.2%
55.9%
S&P 400
47.1%
56.9%
Russell 2000
40.0%
52.4%

Table 1: A comparison of the percentage of the time various indexes close higher in the first week of the year to the percentage of up weeks in their history.

Table 1 shows that the NASDAQ composite index has a history of outperforming in the first week of the year, but the Russell 2000 actually performs significantly worse over that time frame. Monthly results are shown in Table 2.

Index

Percent of time stocks close higher in January

Percentage of all months closing higher

Nasdaq Composite
79.2%
63.8%
S&P 400
76.5%
62.6%
Dow Jones Industrial Average
60.7%
57.2%
Russell 2000
60.0%
57.5%
S&P 500
58.0%
57.3%

Table 2: A comparison of the percentage of the time various indexes close higher in January to the percentage of up months in their history.

We can see in Table 2 that the January effect is most pronounced in the speculative NASDAQ Composite and Midcap stocks. These results show the value of testing conventional wisdom.

The performance of the NASDAQ Composite index is largely driven by the biggest names within that index. At the beginning of the year, investors often review a list of the best performing stocks from the previous year and may be buying last year’s tech winners. The Midcap index is an underfollowed group of stocks that typically fare better than small cap stocks. They have survived the often-difficult start up phase and are more likely to be thriving businesses. These stocks are also more likely to be found on the list of last year’s top performing stocks.

In other words, based upon this simple research, we can conclude that relative strength partially explains the January Effect in stocks. Recent performance often drives investor behavior. Rather than trying to select the best stocks, a difficult challenge for even the professionals, ETFs offer a practical way to implement these ideas.