As trading gets underway in 2022, the U.S. stock market faces an uncertain future.

Will traders take profits after the widely-followed S&P 500 index more than doubled in 2021 or is the January Effect going to give the market an extra boost?

The January Effect continuously fascinates market participants and analysts because it frequently sets the tone for the rest of the year.

This is why knowing what it is, when it occurs, and how to profit from it is essential in starting the year strong! Read on to learn more.

What is the January Effect?

The January Effect is a hypothesis or theory, which says that stock prices tend to rise more in January than during any other month.

Sound familiar? You might be thinking of the “Santa Claus Rally” which is when stocks rally during the month of December, usually, in the last week of the month.

The January Effect was first observed by legendary investment banker Sidney B. Wachtel in 1942.

Using data going back to 1925, Wachtel noticed that small-cap stocks kept performing better than their large-cap counterparts, and most of this unexpected performance happened before mid-January.

While the real cause of this phenomenon is still up for debate, there are a couple of popular theories.

Does the January Effect really happen?

Since Wachtel revealed his observation to the public, the January Effect has been studied by many researchers, most of whom have found that the effect does indeed happen regularly.

In one study done by investment firm Salomon Smith Barney, from 1972 to 2002, some stocks outperformed by 0.82% during the month of January but underperformed in the other months of the year.

The study found that the small-cap Russell 2000 index outperformed the large-cap Russell 1000 index probably because of the January effect.

Another study analyzed stock market data from 1904 to 1974, researchers found that stock gains were five times more than average in January.

Several other studies have confirmed some tendency for the effect to occur.

Still, the effect has appeared to diminish in recent years. Although trying to explain the reason for the deceleration of the January effect is not easy, there are some theories.

First, because many traders are aware of the likelihood that stock prices may increase in January, there is a more transparent chance to proactively prepare for it.

Also, trading for purpose of tax-loss harvesting has been made less relevant by the rise of more tax-sheltered retirement vehicles, such as 401(k)s and individual retirement accounts (IRAs).

Causes of the January Effect

No one knows the definitive reason why there is a seasonal tendency for the stock prices to rise in January and gifts traders with positive returns to kick off the year. There are, however, many theories. Some include:

• Tax-loss selling

Tax-loss selling or tax-loss harvesting is a strategy that stock traders and individual investors use to improve their overall portfolio returns at the end of the year.

This strategy involves selling some stocks or securities that have dropped in value and using the losses to help offset capital gains tax liability, thus reducing one’s total tax bill.

These massive sell-off pushes stock prices lower at the end of the year. As a result, it also draws many traders who are interested in the lowly-priced stocks, and consequently, drives prices back up in January.

• Repurchases

Traders use year-end cash bonuses which are usually paid in January to buy stocks; and those that engaged in tax-loss harvesting in December make buy back stocks in January, thus triggering the January Effect.

• Window dressing

Window dressing refers to the practice of a mutual fund or hedge fund making cosmetic changes to its portfolio just near the end of each financial quarter.

They sell underperforming stocks and buy overperforming stocks so that when their portfolios are reviewed, investors will think that the fund has a successful portfolio while in essence, it incurred losses.

• Investor psychology

With the excesses of the holidays behind them, many stock traders usually set out on New Year’s resolutions with the promise to better their lifestyle in some way.

Following up on New Year’s resolution starting from January, and the energy and momentum associated with the need to start trading in order to save for the future tend to cause a rally in stock prices during the first month of the year.

Will there be a January Effect in 2022?

According to historical data compiled by Yardeni Research, the widely-followed S&P 500 index has gained an average 1.2% in January, making it one of the best months for stock traders.

Therefore, many traders and investors will be paying close attention to see how the first five trading days of the new year play out.

The stock market has been edgy in 2021 because of Covid-19 concerns. But if the market maintains its current upward trend, small-cap stocks are likely to post a strong performance in January.

With just a few days before we usher in the new year, it looks like Wall Street will experience the January effect.

“We expect the upcoming ‘January effect’ to be even more pronounced this time around given extreme positioning and sentiment, with a potential for a large High Beta squeeze. Funding could come from increasingly crowded low vol. stocks where investors are again paying record premium for that shelter,” MarketWatch recently quoted JPMorgan Chase strategist Dubravko Lakos-Bujas as saying.

Preparing for the January Effect

There are a couple of ways traders can prepare for the January Effect since it only happens in certain contexts.

If your taxable brokerage account has some small-cap stocks, you could perhaps make periodic additions in the last few days of December as you look for a possible price increase in January. If that happens, you would have a chance to rebalance to your original asset allocation and lock in some gains.

However, the better guidance is that you should not attempt to time the market to benefit from perceived seasonal anomalies.

While you could end up with a winning set of stocks in the short run, that might also disturb your overall asset allocation and consume a lot of your time and energy.

Bottom Line

Historically, researchers have discovered that January tends to be a strong month for U.S. stocks, particularly small-cap stocks that underperformed the prior year.

Many researchers have studied the January Effect and most of them have confirmed its existence.

If history is any guide, stocks of smaller companies that have performed poorly in the previous can bounce back quite strongly during the first few days of January.

However, any trading strategy as simple as buying particular stocks in a given month should be executed with caution.

With twelve months to go, there is a possibility that stocks performing well during one month of the year could just be random.

Furthermore, since there is a lot of smart money in the stock market, a strategy that worked in the past might be copied by other traders in the future, making it less effective.