The “January Effect” refers to the tendency of small-cap stocks (as a group) to outperform their large-cap counterparts in late December to early January..
Although it may be hard to believe, we are in the final stretch of 2025. As the market closes on Thursday (11/20), there are just 26 trading days left in the year. As long-time readers of this report are already aware, there are several market tendencies or historical biases that we highlight throughout the year. In many cases, these are observations that have been documented in the Stock Trader's Almanac; including items such as market seasonality, the "January Barometer," and even performance patterns surrounding presidential election years. Another historical tendency we discuss each year around this time is the "January Effect." The “January Effect” refers to the tendency of small-cap stocks (as a group) to outperform their large-cap counterparts early in the calendar year. However, when any seasonal trend becomes widely accepted, we tend to see the market adjust accordingly. In the case of the January Effect, we have seen this phenomenon move further forward in the calendar over the years.
According to the Stock Trader's Almanac, "In a typical year, the smaller fry stays on the sidelines while the big boys are on the field. Then, around early November, small stocks begin to wake up, and in mid-December, they take off."
Consider the table below, which examines the last 28 years of market activity, and the results of a theoretical $10,000 portfolio that would invest each year in the standard “January Effect” move. Accordingly, this table reflects the returns of someone buying the Russell 2000 Small Cap Index (RUT) and selling the S&P 500 (SPX), capturing the spread between the two. The first table shows the returns of someone entering this trade (based upon the closing price of each index) at the end of a year and holding the position through the end of January. As you can see, the results show no significant bias toward small-cap outperformance. The second table, however, captures the hypothetical returns of someone taking the same approach, but entering the trade in the middle of December, and holding through the middle of January. Since 1997, small caps have now outperformed large caps by an average of 1.26% during the modified holding period.
This year, the Modified January Effect didn’t play out as both large and small caps were in the red with small caps underperforming by almost 2%. But, in 2023 the Russell 2000 outperformed the S&P 500 by 3.7% and in 2021, small caps had the largest performance differential in our study period, outperforming SPX by 6.35%.
There is, of course, no way to know if the modified January Effect will play out in any given year. Small caps have trailed large caps by almost 5% over the last month, so the current trend may not be favorable for the January effect, but the underperformance does possibly set small caps up for a late year rebound.
Below are a few points about and possible causes of the January Effect:
- Lagging money managers who fear for their jobs will cut their losses in small-cap stocks and invest in blue chips to avoid ending the year at the bottom of the performance rankings. They will then look to re-establish their aggressive positions in January, thereby helping fuel small stocks on a relative basis.
- The lower the institutional ownership of the stock, the greater the January effect, suggesting that individual trading is most responsible for the effect. This makes sense as taxes have a greater impact on individual investors than institutions.
- The years most likely to experience a pronounced effect are those preceded by large losses in the prior year, suggesting tax-loss selling is a key driver to this effect.
- The effect tends to be greater when the US dollar is strong, and weaker when the dollar is declining.
- Year-end bonuses, distributions, and gifts may go into the market, providing a boost in demand early in the year, the major effect coming from corporate retirement plans.
- Money managers are more likely to place riskier bets at the beginning of the year but bring their portfolios closer into alignment with the S&P 500 as the year progresses to protect themselves from any major deviation from their bogey late in the year. Risk tolerance is typically relaxed at the very end of the year, and more so into early January.
