By Randy Farina, Senior Portfolio Manager
At the start of a new year, investors often approach the markets with a mix of optimism and curiosity. Historically, this optimism can translate into stronger stock performance in January. The so-called “January Effect” is driven by two factors: tax-loss selling at the end of the previous year and the fresh capital that followed as investors repurchased positions after the required 31-day wash-sale period.1 This cycle, combined with the belief that a new year means a clean slate for the markets, fuels enthusiasm. But over the years, the January Effect has faded, becoming more of a seasonal relic than a reliable pattern.
One of the main reasons the January Effect has lost its power is the structural shift in market dynamics. The dominance of passive investing has fundamentally changed the way capital flows into markets. Today, about 53% of new capital flows into passive indexed investments.2 These strategies don’t actively hunt for seasonal opportunities or anomalies, which means that patterns like the January Effect are unlikely to generate the same outcomes they once did.
Still, 2025 presents conditions that could create a short-lived resurgence, even if only by coincidence. A new administration has entered office, bringing promises of pro-business policies and reduced regulation. Interest rates remain in a cutting cycle, which typically supports equity markets. Small caps, which have lagged behind large caps in recent years, are positioned to benefit from this backdrop.3 While the January Effect may no longer provide a consistent edge, these tailwinds could create short-term strength in small caps early in the year.
However, investors should view any January rally with caution. High valuations across U.S. large caps suggest that this isn’t the time to chase market momentum. The Magnificent Seven stocks, for instance, dominate market capitalization and trade at elevated price-to-earnings ratios.4 History shows that starting at high valuations often leads to muted returns over the long term.5
For those questioning how to interpret the January Effect, it’s important to recognize its role as a potential tactical opportunity rather than a strategic guide. The optimism that often accompanies the new year can create temporary tailwinds, but sustained performance requires attention to market fundamentals. The broader lesson for investors is to remain focused on long-term goals rather than short-term phenomena. Market cycles will continue to fluctuate, and seasonal patterns like the January Effect are unlikely to provide consistent alpha in today’s market.
If you have any questions about how the January Effect might apply to your portfolio, or if you’d like to discuss rebalancing opportunities, reach out to your Exencial advisor. We’d love to hear your perspective as we continue into 2025.
Sources
- Investopedia (12/20/24) - January Effect: What It Is in the Stock Market, Possible Causes
- Morningstar (1/20/25) - US Fund Flows: Picking Up Steam in 2024
- Zacks Investment Research (1/8/25) - Can Small-Cap ETFs See the January Effect in 2025?
- Axios (12/20/24) - Stock market is more concentrated than ever, raising risks
- Business Insider (11/23/24) - The stock market is soaring. Wall Street's biggest names say to be careful
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The Magnificent Seven is a group of high-performing U.S. stocks and includes Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.
Price-to-Earnings (P/E) Ratio is a stock valuation metric comparing a company's share price relative to its earnings per share (EPS). The ratio helps to assess the relative value of a company's stock.
