Financial markets are influenced by numerous factors, including several notable seasonal patterns that may guide investor and trader behavior. These often-cited anomalies include the strategy to “Sell in May and Go Away,” routine “Quarter & Year-End Rebalancing,” the popular “Santa Claus Rally,” and of course, the historical “January Effect.”
The January Effect references historical data suggesting that market prices tend to rise more significantly in January than in any other month. This phenomenon was most pronounced among small-cap stocks from the 1940s through the mid-1970s. Its reliability began to wane from 1980 to 2000 and has been inconsistent since.
Traditional Drivers of the Effect
When the effect does manifest, it is typically attributed to behavioral and structural factors at the turn of the calendar year:
- Tax-loss harvesting: Investors may sell underperforming shares in December to create capital losses and then repurchase those same shares when the calendar flips over.
- Year-end bonus investments: Many people receive annual bonuses in December or January and choose to invest some of the proceeds in the stock market, potentially driving prices higher.
- Investor psychology: It’s a common notion that people tend to start new things at the beginning of the year, including putting money into the stock market. The “new year, new beginnings” mindset can be difficult to shrug off.
Midterm Elections: A Different Pattern Emerges
While the January Effect's influence has faded, the cycle of midterm election years introduces a distinct set of market dynamics. Over the last 20 years, January and February have not been all that bullish, averaging gains of 0.3% and 0.2% respectively. The inherent uncertainty surrounding these elections has made midterm years challenging, with average returns falling below 5% since 1950.
There may be a silver lining as markets tend to follow a pattern around midterms.
- Pre-Election Opportunity: Data from the last 90 years reveals that a significant drawdown in the S&P 500, typically occurring 12-18 months before midterm elections, has historically presented a compelling buying opportunity.
- Post-Election Rally: Following the election, equities often demonstrate strong performance over the subsequent three, six and 12 months.
S&P 500 Performance Before and After U.S. Midterm Elections**
Volatility as a Key Indicator
Midterm election years are also notable for being the most volatile within the four-year presidential cycle. This heightened volatility, in my experience, stems from the market's aversion to uncertainty. Elections can significantly increase investor apprehension regarding potential policy shifts and their economic implications.
This increased uncertainty is clearly reflected in option markets. For instance, current observations show at-the-money implied volatility for January 2026 expiring options hovering around 13%. As we look further ahead to March, this implied volatility rises to over 15%, and it continues to climb toward 20% as the year progresses and midterm elections draw nearer.
The historical trend of increased uncertainty around midterm elections directly correlates with elevated equity volatility. This heightened implied volatility can be tracked by examining option chains in major indices such as the E-mini S&P 500 Options (ES), the E-mini Nasdaq-100 Options (NQ), and the E-mini Russell 2000 Options (RTO).
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