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A popular perception among investors and stock watchers is that stocks tend to increase in price after the New Year. There is some truth to this, but the facts don't fully support this perception. Its accuracy depends on the type of stocks involved and the precise time frame being examined.
The perception that stocks will go up after New Year's Day is known as the "January effect" and focuses mostly on the first five trading days of January. Market statistics show that in the last 38 years when the market was up in this time frame, it finished higher for the year as a whole almost 87 percent of those years. However, in a recent 15-year period, stocks rose only 50 percent of the time on the first trading day of January and at the end of the first week. More significantly, stocks were down two-thirds of the time at the end of January.
If you examine the performance of small-cap stocks as opposed to the broader market, the January effect is more accurate and relevant. Market data dating back to 1925 show that small-cap stocks outperformed the broader market each year during mid-December to the end of January. For example, small-cap stocks increased an average of 8.6 percent during this period for the years 1996 to 2009, while the Standard and Poor's 500 -- a broad index of major stocks -- only increased 1.2 percent.
This effect on small-cap stocks has a few causes. Many investors, including fund managers, sell these stocks at the end of December to secure a tax loss, and this tends to lower their prices. These same investors then will rebuy these stocks again in January, which tends to increase their prices. "Window dressing" is also responsible for some of the January effect; this is when fund managers dump underperforming stocks from their portfolios at the end of the year to enhance their portfolio's image. In January, many of these managers will rebuy these same stocks.
Investors and fund managers sell and then repurchase small-cap stocks mostly for objective reasons, though subjective forces do come into play. Many people, including investors, tend to feel an increased sense of optimism at the beginning of the year. This encourages bullish buying behavior in January and suppresses bearish selling behavior. This is particularly true for small-cap stocks, which usually provide the best opportunity for the largest gains. Thus, they become attractive to all the optimists among investors.
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