The January Effect And Stocks' Upside Bias - Buy The Dips

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Includes: BIBL, CHGX, CRF, DDM, DIA, DMRL, DOG, DUSA, DXD, EDOW, EEH, EPS, EQL, EQWS, ESGL, FEX, FWDD, GSEW, HUSV, IVV, IWL, IWM, JHML, JKD, OMFS, OTPIX, PMOM, PPLC, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RVRS, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPHB, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USMC, UWM, VFINX, VOO, VTWO, VV, ZF
by: Markos Kaminis
Summary

Tax-loss selling is exhausted.

Equity valuations were discounted as a result of late 2018 declines.

Capital flows have turned favorable as stocks are reacquired.

What to look to once balance is restored to the market.

Stocks came up against a seemingly endless stream of negative news flow through the fall and into the winter of 2018. While several serious risks and threats still feel currently pertinent, another important change has occurred since the turn of the year. Tax-related selling has concluded for institutions and individuals, and the opportunistic acquisition of deeply discounted shares has replaced prior selling. I am suggesting that the stock market has likely bottomed near term, barring an outlier extraordinary downside catalyst. In other words, we have a January Effect this year. Looking beyond the early run already enjoyed, the outlook will continue to depend on: government policy and especially trade developments with China; Brexit developments; U.S. economic health and how the U.S. Federal Reserve responds; and geopolitical developments. However, there should be an upside bias for stocks near term, providing for buy-the-dip opportunities.

Around the turn of the year each year, I look for opportunity in asset classes and securities related to the January Effect. It is where tax-loss selling compounds losses for a security or an asset class into or near the turn of the year, driving down values excessively but opening opportunity for the reacquisition of those assets around that time.

1-Year Chart of SPDR S&P 500 Trust ETF (SPY)

Chart SPY data by YCharts

You will have to forgive me for not publishing preemptively this year, as I was busy with a non-profit endeavor. If you can believe it, I started this report in late December in expectation of a turn for stocks into early 2019. As I first wrote, the S&P 500 Index was off roughly 6.9% year-to-date through the close of trading on December 27, 2018, and it was 15.4% off its high for the 52 weeks into the date. The Dow Jones Industrial Average (DIA), Nasdaq 100 (QQQ) and the Russell 2000 (IWM) had likewise marked losses, and severely so off their highs for the year. However, since the close of the year, the SPDR S&P 500 is up significantly, while riskier sectors of the market are up more.

Stock Sector ETF

YTD Performance Thru 01-14-19

SPDR S&P 500 Trust ETF (SPY)

+3.0%

SPDR Dow Jones Industrial Average ETF (DIA)

+2.5%

Invesco QQQ ETF (QQQ)

+3.2%

iShares Russell 2000 ETF (IWM)

+6.2%

Invesco S&P 500 High Beta Portfolio ETF (SPHB)

+6.5%

The sectors of the market that were sold off to a greater degree, or which are deemed to be at higher risk (high beta), have been reacquired at a faster pace since the start of the new year. But the prior capital flow trouble had to have some fundamental catalyst to begin with (that still matters), providing the opportunity for investors to take capital losses for tax purposes into the close of 2018.

Blame it on the Uncertain Economic Outlook

The damage to stocks has been for multiple reasons, but it has been greatly due to uncertainty about the forward economic outlook. That uncertainty has been reinforced by U.S. trade disputes and their potential relative impact on prices and the economy. We have also observed relative softness in home and auto sales, though for autos after peak sales were marked.

Importantly, economists’ GDP forecasts are off the pace of the last two quarters. CNBC’s Rapid Update shows the consensus of 9 economists’ forecasts for Q4 GDP at 2.8%. That compares to Q3 2018 reported GDP growth of 3.4%, with stronger Q2 growth of 4.2% before that. When it last reported to the nation on December 19, 2018, the U.S. Federal Reserve’s economic forecasts showed a consensus view for 2019 GDP growth moderation to 2.3% (revised from 2.5% at September’s meeting); that would be down from 3.0% for full 2018.

Adding to uncertainty about the economic outlook, the U.S. treasury security yield curve has been flirting with inversion. The term “yield curve inversion” refers to when long-term treasury security rates are lower than short-term rates. According to a report published in March by the San Francisco Fed, the phenomenon has a habit of preceding economic recessions in the U.S., with every recession of the last 60 years having been preceded by a yield curve inversion. It’s an indicator the market trusts, and so, as the spread between durations has narrowed toward inversion, equities have begun to react violently.

However, the time from the inversion of the curve to economic recession can vary substantially from 6 to 24 months. If the economy will not recess until late 2020, a stock market discounting for it today would be prematurely doing so, and equity values would likely recover as the economy and corporate earnings continue to grow.

Meanwhile, other threats to the global economy loom, including the possibility of a “no-deal or hard Brexit,” which the Bank of England (BOE) states would send the British pound down and push the United Kingdom into recession. The BOE said that in that case, the UK economy could shrink by 8% and home prices could lose a third of their value. Brexit details remain undecided and threaten global securities market upheaval in March if the divorce pushes through without a transitional road map.

Selling Begot Selling… and then Buying

December was a miserable month for stocks, as selling begot selling, though this time, I believe for tax-related purposes. Sure, there remained the relevant fundamental catalysts behind the selling, but those were also present in early January, when equities began to rally. January’s early rally is your evidence that much of the selling in December was exacerbated by investors seeking the tax benefits of capital losses, which, to a limit, can be counted against income for tax purposes and thus lower one’s tax bill for tax year 2018. Stocks began higher immediately after a capitulation moment on New Year’s Eve when the SPDR S&P 500 sank 2.6% in one trading day.

1-Month Chart of SPY

Chart SPY data by YCharts

Why did stocks start higher before the turn of the year?

The early start to the rally was probably because many investors anticipated the tax factor and sought to put capital to work before the masses. It’s my view that the Santa Claus rally that often occurs for stocks has a lot to do with similar investor attempts to beat the broader market to turn of the year opportunity.

More on the January Effect

When investors/tax payers hold an issue that carries a significant paper loss, and at the same time are responsible for taxable capital gains on stocks they have already sold in the same tax year, it makes tactical sense to take a loss or two, negate a capital gain and/or max out on a taxable (or accountable) capital loss. To further clarify, investors can also count capital losses against ordinary income to a certain limit.

Strategies employed around this phenomenon must account for the 30-day wash sale rule, which requires the investor selling for a loss to wait at least 30 days before reacquiring that same security. Otherwise, the loss is not accountable for tax purposes. You might do this if you believe in a stock’s long-term potential but have a loss on record currently. Some will buy a similar security to replace the sold security in order to minimize risk of missing out on any industry or sector appreciation opportunity expected or to keep industry or sector presence in a diversified portfolio. Many might sell well before November’s end in order to reacquire the same shares cheaper in December, before the turn of the year with the masses.

I believe the January Effect, or its precursor in tax-related selling, had a lot to do with why Facebook (FB) and other strong growth stocks got so cheap into the close of the year. Yes, I’m aware of the events that occurred around Facebook and the negative news flow, but I believe the gains we have seen in those same shares since the turn of the year or just before it validates this argument as well.

So, where do stocks go from here?

While I believe there is still an upside bias for stocks, thanks to the exhaustion of tax-related selling and a likely imbalance of buyers to sellers that exists today, we still contend with risks and threats on a very short-term basis. This week, the Brexit threat and concerns about earnings season, which I believe are overdone, could give investors a buy-the-dip opportunity that I believe should be taken advantage of.

The longer-term outlook for stocks will still depend on the U.S. economy and relative developments, and how the U.S. Federal Reserve responds. The fully employed U.S. workforce should have something to say about that. I expect that given an increasing duration to full employment, many Americans are graduating out of burdensome debt holes into a position where they can purchase homes and autos. Those same Americans are generally in a better position to take vacations, eat out and otherwise spend a little more money each day. So, while economic growth may slow a bit, the economy should still be marking strong growth and reflecting a healthy state of affairs for America in 2019. And, as I argued in a recent article, the Fed should be friendly to the markets near term.

After January?

Halfway through January, it seems clear to me that stocks have benefited from the January Effect and its precursor, tax-loss selling into the close of 2018. That selling, which was catalyzed by other fundamental factors that started the market lower earlier in the year, created value in many shares. Investor appreciation for that value, sometimes in stocks that had been sold for tax purposes at least 30 days prior, has drawn in bidders. An imbalance of buyers to sellers resulted after the exhaustion of tax-loss selling and the advent of bargain hunting thereafter. Moving forward, I still see value in the market and believe stocks still have an upside bias. In the short term, though, we still could see dips in the market on other relevant issues. I would view those as buy-the-dip opportunities as the market maintains an upside bias. Beyond the January Effect, the market will again look mostly to the economy, Federal Reserve response, and other relevant factors like trade policy with China as it seeks certainty on the forward economic outlook.

Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.