Landon Capital


In 2022, investors have seen inflation rise at rates not seen since the 1970s, causing the Federal Reserve to go on an unprecedented rate-hiking schedule. Unsurprisingly, the stock market reacted negatively, entering a bear market.

With the Russell 2000 down 23%, the S&P 500 down 20% and the Nasdaq Composite off by 34%, many investors are anxiously waiting to put 2022 in the rearview mirror. In fact, 44% of Russell 2000 stocks are down at least 30%, as are 54% of Nasdaq stocks and 25% of S&P 500 stocks.

Will 2023 serve equity investors any better?

According to Bloomberg, the average forecast for the S&P 500 in 2023 puts the index at 4,009 at the end of the year. However, the consensus of the strategists from Wall Street’s biggest firms covers a wide range — from continuing a full bear market to expecting a stock market recovery. Historically, market forecasters rarely get it correct, but for 2023, the average suggests a minuscule 12-month increase.

However, the outlook for small-caps may be brighter. In fact, Bank of America Securities is actually advising investors to look for small-caps in 2023 to help hedge against a declining market. The firm forecasts that small-caps are poised for 12% annual returns over the next 10 years, versus only 5% annual gains for the large-cap S&P 500 over the same timeframe.

For now, some investors may be restricting their view to the near term with expectations that stocks will rise meaningfully in the next 30 days due to the so-called “January effect.” It’s the theory that stocks, especially small-cap stocks, climb significantly in January.

Unfortunately, the statistics suggest that the January effect may be virtually a game of chance. There are some reasons to think the January effect might work in 2023, especially for small-cap stocks, but it’s far from a certainty.

Proposed drivers of the January effect

Discussion of the January effect dates back to at least the early 1940s. The earliest focus of the January effect was on small-cap stocks outperforming their large-cap counterparts, but over the years, it has been expanded to cover the stock market in general. As with any theory, many market watchers have tried to prove or disprove the January effect, suggesting potential causes for it.

One idea is that January brings a rally due to a sudden increase in buying due to heavy tax-loss harvesting in December, which triggers a selloff. Investors often engage in tax-loss harvesting in December to offset their realized capital gains at the end of the year, and the theory goes that they repurchase the stocks they sold in January.

Another suggestion is that investors use their year-end cash bonuses to buy more stocks in January. Investor psychology has also been suggested as a contributor to the January effect. Some investors might set new year’s resolutions to invest more or might simply think January is the best month to start a new investment plan.

Whether or not the January effect is real, one thing is clear going back to its roots involving small-cap stocks. Any meaningful changes in stock prices overall tend to have an outsized impact on small-caps because they are less liquid than the stocks of larger companies and because they tend to have a higher proportion of individual retail investors holding them than large or mid-caps.

The numbers behind the January effect

The debate over the January effect won’t be over anytime soon, but we can look at history to understand why this theory began and whether it holds water. Overall, evidence for this effect is small, especially when zeroing in stock market history for the last 30 years or so.

Multiple data sets on this theory have been generated over the years, and the consensus is that even if the January effect worked for small-caps at one time, it probably doesn’t anymore. The January effect can be seen most clearly when looking at stock market returns back to 1928.

The S&P 500 averaged a gain of 0.2% across all months but January while averaging a January gain of 1%. However, between 1989 and 2019, January averaged a gain of 0.4%, while all other months averaged a gain of 0.6%.

Over the past 30 years, about 57% of the Januarys have been winning months, while 43% are losing months — not much better than flipping a coin. In the last nine years, January has been positive only three times, and the average return is actually in the red. This is particularly noteworthy because major U.S. stock indices were particularly strong between 2014 and 2021.

The January effect on small-caps isn’t much better

For small-caps, the January effect works slightly better, even though the original theory was specifically about small-caps. The Russell 2000 averages a gain of 1.4% across every January since 1979, but the win rate is only about 55%, according to data from Bank of America. The firm also discovered that small-caps typically have their best part of the year in November and December rather than January.

In 2022, the Russell 2000 rose a bit in November but declined into the end of the year, only managing a slight turnaround in the last few days of December. Additionally, small-caps outperformed large-cap stocks between mid-May and early November.

For an even clearer picture of the January effect, one study noted that January 1975 and 1976 saw massive gains that throw all the above data sets off significantly. After eliminating those years, the trendlines for stock returns become flat. In fact, the January effect disappears from the small-cap Russell 2000 entirely.

What might cause the January effect to work in some years

As the statistics show, it’s virtually impossible to tell whether the so-called January effect will be in play from one year to the next. However, various studies offer signs investors might look for when trying to make that determination each year.

For example, one study published in February 2003 found that the January effect is negatively correlated with actual and expected real GDP growth, inflation, and return of the year. On the other hand, it’s positively correlated with volatility — something we’ve seen more than enough of this year.

One of the arguments against the January effect in recent years is that it simply doesn’t work anymore because the market has already priced it in. However, there are signs that January and potentially the rest of 2023 could be good for small-caps.

Why January 2023 and beyond might be good for small-cap stocks

While the data tells us the January effect might be little more than a myth, there are reasons to think 2023 might be positive for small-cap stocks, particularly since they’re selling at a 30-year low relative to their large-cap counterparts. For example, one study found that small-caps tend to outperform in the two years after a recession.

Of course, whether we’re still in or have exited a recession or whether one is still coming in 2023 is up for date. However, using the traditional definition of a recession, the U.S. did technically qualify as having been in one in early 2022 when it recorded two straight quarters of negative GDP.

In another study, Bank of America discovered that the January in the year before a presidential election year tends to be bullish for stocks. Since 1928, January has been the best month of the year during pre-election years, averaging a 3.4% gain and being up 83% of the time.

In a separate study, Bank of America recently pointed out that small-caps outperformed the broader market during the economic downturns in the 1970s and 1980s—other times when the Federal Reserve was fighting historically high inflation like it is now. Of course, debt can be a concern when interest rates are rising, and many small-cap companies carry significant amounts of debt. However, BofA believes those concerns are already priced in.

Sentiment will also affect the direction and pace of the equity market in January. The Stock Trader’s Almanac has suggested that small-cap stocks tend to do better during periods of increased uncertainty while lagging behind larger stocks during sizable bull moves. Additionally, small-cap stocks have often outperformed large-caps following bear markets.

Why large-cap names could do better in 2023 too

However, large-cap stocks could do better in 2023 as well because they are more affected by currency changes than small-caps. The dollar rallied big time in 2022 as the Fed raised interest rates, which may have been partially to blame for the damage done to large-cap stocks.

On the other hand, most small-cap companies sell mainly or even exclusively within the U.S., limiting their exposures to international markets and protecting them from dramatic currency movements. As the Fed wraps up its rate-hiking cycle in 2023, the dollar is likely to weaken against other currencies, potentially enabling large-cap stocks to perform better than they did in 2022.

Of course, stock price movements are never guaranteed, so as always, investors invest at your own risk.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.