The Santa Claus Rally is Over, Now Comes the January Effect

By Neil Chapman, JD, CFA
Director, Chief Investment Officer

The Santa Claus Rally and the January Effect are two seasonal anomalies that are said to occur in the stock market. The Santa Claus Rally refers to the tendency for the market to rally during the last five trading days of the year and the first two trading days after New Year’s. The January Effect refers to the market’s tendency to have stronger returns during the month of January than other months of the year. Some investors even consider the two anomalies to be connected, with the Santa Claus Rally resulting from investors buying stocks in anticipation of the rise in stock prices during the month of January.

As we find ourselves in January, it would appear to be a good time to investigate the January Effect.  We will review some of the studies and research on this anomaly and try to determine if it has any value to investors today.

What does the research say about the January Effect?

Sidney Wachtel is considered to be the first to note the January Effect in his article, “Certain Observations on Seasonal Movements in Stock Prices” (The Journal of Business of the University of Chicago, April 1942). In the article, Wachtel notes that the Dow Jones Industrial Average from 1927 to 1942 showed “frequent bullish tendencies from December to January.” Further, he noted that the index increased in value eleven of the fifteen years, and the eleven increases in value were of considerable magnitude. He also introduced the idea that this could be caused by year-end tax-selling on the part of individuals and corporations operating on a calendar year basis, and the subsequent buying of these depressed stocks.
 
I would note that Wachtel’s study of this seasonality pertained to a period from the third Saturday in December to the third Saturday in January. As such, the study did not show a purely January Effect, but in some sense a combination of the Santa Claus rally at the end of the year, along with stock appreciation through the first three weeks of January. Wachtel also observes that there is an even more “reliable” seasonal trend, bullish in character, that takes place from the middle of June to the middle of July (whether this is early evidence to refute the saying “Sell in May and Go Away” is a question for another day).
 
In the decades since Wachtel’s observation of this seasonal anomaly, numerous articles showed the existence of the January Effect, and looked at theories that might explain the above-average stock returns during January. A more recent, and more extensive, study was done in 2005 by Haug and Hirschey. (“The January Effect”, School of Business, University of Kansas) The paper updated evidence of the January Effect in stocks for both large-cap and small-cap stocks and addressed a couple of the behavioral explanations that might account for the January Effect.
 
The authors used value-weighted (market cap-weighted) returns for the years 1802-2004 to assess the January Effect on large-cap stocks. For small-cap stocks, they used equal-weighted returns for the years 1927-2004 (the period for which data is available). An equal-weighted index gives smaller companies greater relative influence than would be true in a value-weighted index. The authors calculate return premiums for the month of January, defined as the return earned during January minus the average rate of return earned during the other eleven months of the year.
 
The authors found that value-weighted returns show little evidence of a January Effect on large cap stocks for the years 1802-2004. Using equal-weighted returns, for small-cap stocks, the authors document abnormally high January return premiums over the entire 1927-2004 time period (See the chart below). As a result of these findings, the authors conclude that the January Effect is largely a small-cap phenomenon.

​Haug and Hirschey also address two of the possible explanations for the January Effect. One long-standing possible explanation for the higher returns in January is tax-loss selling in December, followed by reinvestment of the proceeds in January. The authors provide further support for this theory but note that the behavior appears confined to individual investors, as opposed to institutional investors. An additional explanation that has been offered for the January Effect is end-of-year “window dressing” by professional investors who seek to eliminate embarrassing losers from their portfolios prior to the year-end reporting period. The authors offer limited support for this theory by noting that tax law changes have in essence eliminated any tax motivation for institutional investors to sell losers at the end of the year, and therefore ‘‘window-dressing” may be a more likely motivation.
 
An even more recent article, although primarily an analysis of the relation of firm size (small firms) and expected returns, also addressed the January Effect (“Size Matters, If You Control Your Junk”, Journal of Financial Economics, 2018). In presenting the data, the authors separated out the small- cap returns into the returns for the month of January versus the returns for the other eleven months of the year. The data showed that for the period 1926-2012, the average return for the month of January was 2.30%, and the average return for the remaining eleven months of the year was 0.04%. This showed a reliable positive return premium for January. When the authors controlled for quality (factors such as profitability), however, the January return premium was significantly mitigated, but still existed. This finding indicated that lower-quality small-cap stocks explain a portion of the seasonality seen in January.
 
So, what can investors today conclude from the research? 
 
The evidence, presented in numerous articles, supports the existence of the January Effect. More specifically, the research shows that the anomaly is a small-cap phenomenon, with lower-quality small-cap stocks accounting for a significant portion of the January outperformance. We also know that none of the seasonal anomalies occur every year, however, and are likely not the basis of a successful trading strategy. In fact, this year does not appear to be a good example of the January Effect, with small-cap stocks, as represented by the Russell 2000, down over 11% as of 1/21/22. The best approach may be to have an awareness that there is a strong tendency for small-cap stocks to perform well in January. As investors, however, we must always consider macroeconomic and other variables in our investment decisions. As a final thought, I believe including the last week of December (the Santa Claus Rally) in the analysis of the January Effect, as was done in Wachtel’s original article, would be an interesting area of further study.