​The Season of Good Cheer...and Strange Effects to the Stock Market...

Wesley Gray |

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.

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 these two scenarios:

  • “Geez, you underperformed by 10%. And wow, you owned Blackberry (BBRY)? …Why do you own that horrible stock?! You really must be a bad manager.”
  • “Geez, you underperformed by 10%. And wow, you owned Facebook (FB)? …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 hypothesis. 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 Market 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.

Here is the original post from Alpha Architect. For more articles from Wesley R. Gray, visit his blog at Alpha Architect.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 117.43 2.03 1.76 20,201,781
BBRY BlackBerry Limited 7.62 0.03 0.40 3,343,105

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