‘Tis the Season for strange effects in the stock market.

‘Tis the Season for strange effects in the stock market.

December 29, 2015 Momentum Investing Research, Tactical Asset Allocation Research
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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.

Window Dressing

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.

window dressing

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.

Tax-loss Selling

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.

Note: Here is a recent paper that digs into the details of tax-loss selling. Highly recommended. We’ll be covering this for a piece on my WSJ Experts column in a couple of weeks.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.