Mark Twain on December
Mark Twain wrote in Pudd’nhead Wilson, “October: this is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February.”
He was certainly right about October, although this is due less to Twain’s analytic skills and more to the US government allowing mutual funds to shift the end of their tax years from December to October in the late Eighties. He’s also correct that each month has its own oddities. But I think he’s wrong to stick December so close to the bottom of his list.
Why he underrates this month
Why? Three reasons:
1. First of all, almost all other taxable investors, like banks and insurance companies, end their tax years in December. Prior to the rise of mutual funds, year-end tax selling by this group of institutions was the key market mover to watch. This action usually begins in December. The same general rules apply as to mutual funds. A taxable investor wants to match gains and losses so that they offset one another. In order to do that, he has to sell both securities.
2. Portfolio manager performance is normally judged on a January-to-December basis. The manager’s results versus his benchmark index, as well perhaps as those versus his peers, determine whether he receives a bonus–and, if so, how much. In a good year, bonuses can be many times a manager’s base salary. Often, this situation affects the manager’s behavior in December.
A competent portfolio manager typically uses December to reorganize his portfolio to take advantage of what he thinks will happen in the coming year. In particular, if the manager has had a very good year (so his bonus is secure) or a very bad year (so there’s no hope for a bonus), he has every incentive to make changes in December, even if he does this a bit prematurely and loses a bit of relative performance. He’ll be certain to enter the new year with a forward-looking portfolio, rather than one filled up with last year’s ideas.
Only when the manager is on the cusp of some important performance or financial objective does it make sense for him to stand pat in the hope of squeezing out the last few basis points from what is likely a portfolio with aging market relevance.
3. Retail investors also do their tax planning in December, matching sales of winners and sales of losers. Many times, this occurs in the small-cap arena. This selling forms much of the basis for the “January effect,” the strong outperformance of small caps to open the year, which is often just the bounce back of the previous year’s losers in the tax-selling derby.
I had expected this month to be strong in the beginning, followed by a gradual fade to the holidays (the last two weeks of the year is the only time a portfolio manager really has time to rest). This may still turn out to be the case, but if the first quarter of the month is any indication, the ride will be a bit bumpier than I thought.
…aren’t that important
Although the daily ups and downs of the markets may be mesmerizing, remember that they’re not the important thing. Our key task for this months is to put the finishing touches on a strategy for 2010. More on this topic in later posts.