tax selling in 2012; the result on the “January effect” in 2013

yearend tax selling

Yearend tax selling typically has a significant influence on the US stock market during the fourth quarter.  There are three categories of investors involved:

1.  mutual funds and ETFs  About 25 years ago, the IRS allowed mutual funds in the US to change their tax years from a calendar basis to a fiscal year ending in October.  This was to help accounting firms spread their auditing workload and thereby avoid errors.  Every mutual fund complex I know of jumped at the chance.

The result has been that since the late 1980s, tax selling by mutual funds has depressed stock prices during late September and early October rather than in December, as mutual funds sell to reorient their portfolios and to manage the size of their yearly distributions of realized profits.

a non-factor this year

Because mutual funds and ETFs can’t make distributions until they use up the huge tax losses generated by redemptions during the 2008-09 market swoon, yearend selling by funds has been a non-factor in the US stock market over the past several years.

2.  taxable institutional investors, like insurance companies.  A generation or more ago, these were the Wall Street behemoths.  Their tax years end in December.  No one really thinks too much about them anymore, because their effect on markets is usually dwarfed by the actions of mutual funds/ETFs.

This December, however, it looks to me as if they’ve been shifting their portfolios away from bonds and into stocks–and in large enough size to help offset the negative effect of individual investor selling of stocks.

These institutional investors, as well as the mutual funds/ETFs are out of the market this week.  Post-Christmas trading reflects the activity of individuals only.

3.  individuals

a.  the January effect.  This is the bounceback during the first two or three weeks of the new year of stocks that have been depressed by large-scale tax selling in December.  Historically, the January effect has been most pronounced in small-cap stocks trading at under $10 a share–the typical stomping grounds of inexperienced amateur speculators.

Because it’s concentrated in small speculative stocks, neither the selling in December nor the subsequent rise in January have much effect on the major averages.

b.  special for 2012: reaction to impending tax law changes

Although we still don’t know what the new tax rates will be on capital gains, they’re certain to be higher than they are now–probably a lot higher.  This consideration has turned yearend tax selling by individuals on its head.

Instead of selling losers in December and winners in January (recognizing gains in the following tax year), and instead of small cap relative weakness/large cap strength in December, we are seeing the reverse.

stock market implications

1.  If I’m right about December behavior, the January effect for 2013 should be a selloff in small-cap speculative losers, counteracted by a rise in blue chip large cap stocks that have been the target of December tax selling.  AAPL will be the litmus test for this, I think.

2.  The return of taxable institutions to the market in the new year, and the absence of tax selling pressure from individuals, should both be stabilizing influences on stocks in January.  Bonds may be a different story.  But stocks could do surprisingly well, absent further negative developments in Washington.