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Investors love bullish trends like the January Effect – but does this rally even exist like it used to?
The January Effect is stocks' tendency to rise during the first month of the year. It's often paired with the bullish year-end "Santa Claus Rally" as a reason to expect a market bump from December to January.
The biggest market jump in December – January is normally seen on the last five trading days of the year and the first two of the New Year. When isolating that single week, the Standard & Poor's 500 Index has posted an average gain of 1.8% since 1929. Stocks have risen 79% of the time during that week over the past 83 years.
The historical reasons for the January Effect, however, have changed.
Here's what that means for stocks, and for the January 2014 stock market.
Where Does the January Effect Come From?
The January Effect was first defined in 1942 by investment banker Sidney B. Wachtel. It has traditionally been attributed to year-end tax considerations.
As the explanation goes, investors typically sell some stocks they've taken a loss on at the end of the year, so they can deduct that loss from their income tax. Once the new year rolls around, they buy back the same stock, pushing up prices.
But that explanation may be a bit simplistic.
In 1929, the IRS instituted the Wash Sale Rule, which prohibits investors from claiming a loss on a sale and then repurchasing the same stock or a nearly identical stock within 30 days. Investors may be reinvesting the money taken from the previous sale of securities, but that IRS provision seems to debunk the myth that the selling and rebuying for tax purposes is the main share-price driver.
Tax-sheltered retirement plans have also grown in popularity in recent years, ending the need for many investors to sell and rebuy stocks for tax purposes.
Another explanation for the January Effect is the "window dressing" that mutual funds perform toward the end of the year.