‘Tis the Season for strange effects in the stock market.
The efficient market hypothesis suggests that stock prices are always “right” in the sense that stock prices reflect all available information. Of course, during tax season, fundamentals go out the window: I’m selling my losers, and letting my winners ride! And I’m not the only investor thinking like this. But how can savvy investors leverage “seasonality” effects for their own benefit? December and January have traditionally provided smart stock market investors with an opportunity to profit based on investor incentives that have little to do with stock fundamentals. We discuss two effects below: window dressing and tax-loss selling.
In the retail business, “window dressing” refers to the practice of displaying products in a store window to make them appear as attractive as possible, although the effect can sometimes be deceptive. In the investment industry, managers can similarly arrange their goods, also sometimes deceptively.
Here is how portfolio managers can make a silk purse out of a sow’s ear. Managers know they must report their holdings on annual statements that get mailed to clients. But the last thing they want their clients to see on those statements is a lot of loser stocks that underperformed the market — they don’t want these stocks on display! To spruce up their new year’s “windows,” in December the managers sell underperforming stocks and buy recent winners. Now the seasonal window looks much more alluring. Obviously, window dressing is not going to be a cure for bad performance, but the hope is that this activity will at least make them appear to have been doing something reasonable, and reduce client questions when they receive their statements.
Consider the two scenarios:
- “Geez, you underperformed by 10%. And wow, you owned Blackberry? …Why do you own that horrible stock?! You really must be a bad manager.”
- “Geez, you underperformed by 10%. And wow, you owned Facebook? …That is a good stock that has done well. You seem like a good manager so I guess you had an unlucky stretch.”
Clearly, the manager would much rather field the second question, and not the first question.
In general, rational investors seek to reduce their tax bill, rather than increase it. In November and December investors evaluate their portfolios, and sell losers to harvest tax losses, and hold onto winners with large embedded gains. This leads to temporarily enhanced selling pressure on poor-performing stocks, and temporarily decreased selling pressure on strong-performing stocks.
The window dressing and tax-loss hypotheses sound interesting in theory, but what does the evidence say? Richard Sias, in his published paper, “Causes and Seasonality of Momentum Profits,” addresses this question. He finds strong evidence to support the window dressing and tax-loss selling hypotheses. Sias finds that winning stocks outperform losing stocks by 5.52% return in December — the highest of any month. The story in January is dramatically different. Poor performers outperform strong performers by 11.52%, as tax-loss sellers and window-dressers reverse their positions.
How to use Seasonal Stock Markets Effects to your Advantage
The evidence on seasonality gives rise to an opportunity for enterprising investors to position themselves to take advantage of seasonal return momentum associated with window dressing and tax-loss selling effects.
In order to take advantage of the seasonality of return momentum (perhaps in a retirement account where tax effects are minimized), in December, investors should focus on high performing stocks. In January, investors should consider the opposite—sell the prior year’s winners and load up on loser stocks.
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Definitions of common statistics used in our analysis are available here (towards the bottom)