The January Effect is named after an observation made in 1942 by banker Sydney Wachtel. He noted that small cap stocks have tended to outperform the market in the month of January since 1925. The hypothesis rests on the belief that in December stocks tend to decline as investors sell off their losing positions to harvest tax losses and may also sell their winning positions to rebalance their portfolios at the end of the year. In January, many stocks are cheap and the investors rush back to redeploy their capital in these stocks. Annual bonuses paid during December and January also find their way to the market.
Arbitraging the January Effect
An investor wishing to take advantage of the January effect would consider buying beaten down stocks in December as the normal investing community sells them for tax reasons. This enterprising investor would then proceed to sell these stocks in mid to late January once new investment starts coming into these stocks and the price rises.
January effect is normally more visible in small cap stocks as these stocks tend to have more retail ownership compared to large and mid cap stocks which are significantly owned by the institutions and funds. Retail investors are more sensitive to income tax, bonuses and other factors that cause the January effect.
Difficulties in Profiting from the January Effect
Efficient Market Hypothesis suggests that anomalies such as January Effect could not exist, or if they arise, they should disappear rapidly. Either way, in most cases, the anomaly does not present enough of a variance in price to overcome the transaction costs, so this is very tough to take advantage of. For small company stocks, these anomalies can be large if the stocks are less liquid and more volatile. Lack of liquidity creates another barrier to fully exploit the January effect by arbitraging. (see: share liquidity)
Does the January Effect Still Exist?
Not to any significant degree, and when they it does, it is not reliable enough to profit from. One can argue that there are always pockets of sectors or stocks that exhibit this anomaly. In today’s environment, with the advent of automated algorithmic trading, even these transient anomalies are very rapidly erased.
Additionally, the wash sale rules now severely limit how quickly investors can buy back the stock that they sold last year. What could have been a window of few days or weeks between sale and repurchase is now enlarged to a month or more. As a result, the effect is no longer as disproportionate as it used to be.
It is not advisable for the retail investors to make this anomaly a part of their investment strategy. It can not be relied upon.
Please note that the January Effect is often confused with the January Barometer that states “As goes January, so goes the year”.