How The 'January Effect' Inspires The 'Santa Claus Rally'

Santa Claus has been benign even to the markets, as is evident from the typically strong rally witnessed at the end of the year. Named the "Santa Claus Rally," this annual trend refers to the strong upward move in stock prices between Christmas and New Year's. Now, how is this related to the "January Effect"?

The January Effect

The January Effect enunciates that stock prices climb in January due to a host of reasons, including buy back by investors who sold in December for tax purposes, buying by investors who might have received their year-end bonus in January and for sentimental reasons, which prod investors to start from the scratch with a clean investing slate.

Small-Cap Stocks

It is believed that small-cap stocks benefit more from the January Effect than large- and mid-cap stocks, as retail investors, who are predominant among the sellers in December and buyers in January, are likely to lean toward buying affordable small-cap stocks.

The performance of the Russell 2000 RUT, which is a representative index for small-cap stocks, does not suggest a strong January showing by small-cap stocks. Given below is the percentage gain/loss for the index during the month of January.

In comparison, a look at the average monthly gains for the rest of the year, excluding February, show better performance for the average 11-month period versus January.

The Santa Claus rally's verve has also been missing in recent years. Since 2009, the S&P 500 Index has been showing a mixed performance in the week after Christmas. Among the many factors that culminate in the Santa Claus rally are:

• Positive sentiment during holidays.
• Year-end tax-related portfolio adjustments.
• Short-sellers, who create volatility, being away on vacation.

However, going back in history, at least the early January's showing used to be strong. Over the years, however, the January Effect is losing its relevance. One reason could have been the January Effect sets in well before the month rolls in. "It generally pays to get a head start on the January Effect in mid-December," advises Jeffrey Hirsch, editor of the Stock Trader's Almanac.

The January Effect has been widely publicized to the point of it losing its charm over the years. Going by history, institutional traders not wanting to take positions when shares have gone through notable mark ups in January begin accumulating many beaten down stocks in December in their quest to get ahead of the markets. Thus, gains supposedly to come from the January effect is pushed forward to December.

That said, Stock Trader's Almanac sees January's performance to be the predictor for the course of the markets for the rest of the year at least 75 percent of the time. Even as the January Effect's fad is fading, at least this predictive nature of January could make it one of the months to watch for by traders.

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