Is the January Effect reliable indicator for yearly performance?

The S&P 500 and other major indexes are getting off to a slow start to kick off the new year. Some of 2023’s leading stocks including Tesla Inc. NASDAQ: TSLA, Norwegian Cruise Line Holdings Ltd. NYSE: NCLH, Micron Technology Inc. NASDAQ: MU, Apple Inc. NASDAQ: AAPL and Meta Platforms Inc. NASDAQ: META were trading sharply lower, along with the broader SPDR S&P 500 ETF Trust NYSEARCA: SPY. 

Does that mean the January Effect, also known as the January Barometer, is signaling something about the month’s and year’s performance?

The January Effect in stocks is a phenomenon that refers to a historical pattern in which January’s return is predictive of the full year’s return. 

But is it significant? Is January's stock market performance truly an indicator of how the year may go? 

To answer that, let’s step into our time machine go back to 1950 and the formation of the S&P 500’s precursor, the Composite Index. 

January Barometer: Track record of accuracy

Since 1950, the January Barometer has been wrong only 11 times, all the way through 2023. That’s an accuracy rate of about 85%. 

But if we dig a little deeper, we’ll see that between 1950 and 2023, the S&P 500 was up 54 years, which equates to a positive annual return 74% of the time.

That means the January effect may simply be related to the overall tendency of the S&P 500 to show a positive return in nearly three-quarters of years, regardless of what happens in January. 

As investors, and frankly, as humans, we like to think there’s something special about the month. 

It's taxes, not fortune-telling

In fact, there may be, but not in some kind of fortune-telling way. Instead, it’s related to something as mundane as taxes. 

According to an August 2023 blog post from American Century Investments, “The 'January Effect' and Stock Market Seasonality,” the January Effect refers back to a tendency for the market to show gains in the first month of the year.

In recent years, said American Century, “tax-loss harvesting is the most frequent cause cited for the January Effect. After selling some of their stocks at year-end for tax purposes, investors reenter the market in January.”

Tax-loss harvesting is a strategy in which investors sell stocks with a loss. Those losses can be used to offset capital gains. That reduces an investor’s taxable income, which lowers tax liability. 

Swapping out the losers

The investor may then reinvest the proceeds of the sale in a similar, but not identical, asset to maintain market exposure to a desired industry. For example, Pfizer Inc. NYSE: PFE ended 2023 with a loss, although investors can sell a stock and claim the loss any time of year. It’s not necessary to wait until December, although that’s what many investors do.

So imagine an investor who sold Pfizer for a loss but still wants exposure to pharmaceutical stocks. That person can turn around and take the proceeds from Pfizer and put the money into Novo Nordisk A/S NYSE: NVO, which has been flying high on the strength of obesity drugs Wegovy and Ozempic. 

You can see the results of that trade, or similar ones, especially if big institutional investors are selling losers and piling into stocks with more potential. If investors do some portfolio housecleaning as the year winds down, they have cash on hand in January, resulting in greater inflows with the potential to send stocks higher. 

“Similarly, investors re-engaging in the market and rebalancing portfolios after the holiday season may be another source for bullish January behavior,” said American Century.

Not a reliable indicator

However, American Century also pointed out that the January effect has diminished over the years, and should not be considered a reliable investing strategy. 

In addition, it turns out there’s no similar effect with non-U.S. stock indexes, and the January Effect has been diminishing in U.S. small caps. That suggests some kind of anomaly that may have been present in the S&P 500 for some period of time, but whose reliability is waning.

Ultimately, while January's performance may be an indicator of how the year will go, it’s not something you can peg any kind of investing strategy on. Better to simply track your investments, rebalance as needed, use strategies like tax-loss harvesting to your advantage and make sure your investments are lined up with your risk tolerance, financial goals and time horizon.