The January Effect and The Fiscal Cliff

gold12345 (1)The year-end for 2012 has some unusual issues for stock market investors, especially those relating to the uncertainty regarding the fiscal cliff.

The fiscal cliff is not an event that will cause the economy to implode (although it is doing quite nicely without any outside help). It is an event that can have profound effects on the stock market, however. There are two direct influences:

The Resolution of The Fiscal Cliff

The problem will be resolved, one way or another. Be assured that the government is not going to stop borrowing and spending your money. The manner in which it is solved may affect the stock market immediately and the economy longer-term. The stock market is a discounting mechanism which takes future expected outcomes and discounts them back to the present. Regardless of whether it does this effectively or not is beyond discussion here. The point is that this valuation process ensures that markets are more volatile than economies.

If the politicians are seen to have given up on trying to resolve the government insolvency problem (who does not already believe that is the case?) or they are presumed to be hopelessly incompetent (again, this is not news for most), the stock market could plunge. On the other hand, if there is a surprisingly “good” resolution, the market could take off. In my opinion, the possibility of the latter interpretation by investors is unlikely, but stranger things have happened (for example, the re-election of Barack Obama and Rasmussen currently reporting his approval ratings up in the mid fifties). Irrationality, or apparent irrationality, seems to be in control of markets and the country.

The Tax Effect

The January Effect refers to the fact that January stock market returns, on average, exceed those of other months. A common explanation for why is based on the effect of taxes. The idea that investors dump losing stocks prior to December 31 in order to get the tax loss into the current year is common. Most of us have probably engaged in such behavior. This selling is rational in the sense that it lowers your tax liability due only a few months later. If you really like the stock, you can always get back in (but be careful regarding the “wash sale” rule).

Tax consequences do affect investment decisions. Many investment advisers meet with clients toward the end of the year for the express purpose of reviewing portfolios in terms of performance. Frequently, losers are rationalized as sales in order to capture the tax benefit. If there is enough of this happening, then December market levels become depressed as a result. After December, markets then recapture normal their normal level, producing the outsized returns in January.

Academic studies are split on whether tax consequences explain the January effect. Regardless of which side produces the better argument, this January is apt to be especially interesting. Not only are we dealing with the timing phenomenon (selling before the end of the year), we are also dealing with the expectation that taxes are about to rise on the wealthiest individuals (and possibly on many others). Tax rates on capital gains, dividends and incomes are likely to rise. For those affected, the amounts are likely to be substantial.

If taxes contribute to the January Effect, this January is apt to produce a super effect. By super, I am not suggesting that the month will be up, but whatever the tax effect, it will be magnified. If you believe December is depressed in as a result of tax planning that will be recaptured in January, then you likely believe next month offers some profit opportunities.

For those who believe this way, a list of the worst performing stocks in 2012 is a reasonable place to begin your due diligence. Even winnowing that list down by worst performers in November and December or December alone might be useful.

I am not a stock picker per se. I prefer to deal with sectors rather than individual stocks. Given what I believe is coming, the long range is not promising. However, if I believed there was a January Effect to be acted upon, I would likely gravitate toward the precious metals sector. I know, gold is about to finish its twelve consecutive up year, a record that exceeds any other asset I am familiar with. But gold and silver were difficult to trade this year. I suspect my positions in both metals were below that of a buy and hold strategy.

The above comments re precious metals have little to do with the January effect. However, gold and silver mining stocks which usually track the underlying metals had horrendous performance in 2012. Will GDX and GDXJ be beneficiaries of the January effect? I don’t know, but if they are of interest to you this might be a good entry point.

Please consult your financial adviser. I am not one, don’t pretend to be one and never aspired to be one. Do not confuse what is the equivalent of a written stream of consciousness with a financial recommendation.

But do remember, gold mining stocks are unlikely to do well in year 13 (superstitious?) of the gold run unless gold continues to climb. Roll the dice or pass them.

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