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Still Time to Consider the January Effect


If you already understand that supply and demand determine prices, then you'll quickly grasp how to trade the January Effect.


We hear a lot this time of year about the "January Effect." The name suggests that it happens only once a year, so it is understandable why many investors don't bother to learn what it is. But there really isn't anything mystical going on, and its influences are quite normal.

If you already understand that supply and demand determine prices, then you'll quickly grasp how to trade the January Effect. And when you better understand the January Effect, you'll spot even more trading opportunities throughout the year.

1) What Makes the January Effect Unique?

The January Effect happens when it does because of the United States Tax Code. Wake up! Sorry, thought I saw you dozing off there when I mentioned the United States Tax... wake up! Seriously, you don't need to be a CPA for this exercise, you just need to understand that tax consequences on your portfolio are based on whatever happened during a single calendar year.

In other words, if you close out a position in your portfolio before the market closes on December 31, then its profit or loss should be considered in calculating your 2007 taxes. This is not an investment decision. To be sure, the decision to sell may be purely for investment reasons. But unlike any other time of year, that can be augmented and perhaps even overshadowed by tax considerations.

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The loss taken on one stock can offset an equal gain from another stock. If I sold a stock earlier this year for $8000 that I bought previously at only $5000 (yes, I'm just that good) then I must declare a $3000 gain to pay taxes on. If I have another position worth $5000 that I originally bought for $8000 (yes, I'm just that good) then I can sell it and avoid paying taxes on the other stock's gain.

At year-end, investors are more likely to sell their losing positions. So, underperforming stocks tend to continue underperforming into year-end.

2) What Makes the January Effect Work?

The tax code gives investors an extra reason to sell a losing stock, and the calendar year tax basis tends to dictate the timing of those sales. Investors can sell a stock at a loss in January and still get the tax benefit, but they won't get that benefit until after year-end. So, this selling pressure suddenly disappears when the market closes at midnight December 31, when the time value of money meets human nature of not wanting to admit being wrong.

A stock usually slides if the underlying company is underperforming. More shareholders are selling, and fewer investors want to buy. These are, respectively, "supply" and "demand." More shares are being supplied to the market, and fewer investors are demanding them, making price decline. Now add another reason to sell: the tax loss that can help to avoid paying some taxes a couple of months later. This increases supply, which makes price decline further.

Of course that new reason to sell wasn't really a new reason, it just becomes more fashionable at year-end. That reason goes out of fashion quickly when New Year's Eve champagne corks start flying. Now supply and demand can function at normal levels, right? Well, yes, but don't forget that supply was at an abnormal level just hours earlier.

All of a sudden, without increasing one bit, demand's ratio to supply just increased - in some cases considerably. And all else being equal, what happens when demand becomes relatively greater than supply? Price rises. Demand might further exceed supply when some sellers become buyers again, having sold only for the tax benefit, which prohibits them then from re-entering for thirty days under "wash-sale" rules.

3) The January Effect in Practice

Well, this sounds easy, right? Look for stocks that have been declining, find the ones that decline even further into December 31, buy them when the market re-opens on January 2, then choose between the red Ferrari or the black one.

Too easy. Firstly, Ferraris are so last decade. Think Lamborghini. Secondly, if price will pop-up at January 2's open according to the supply:demand equation, then we can't buy later than December 31. And lastly, perhaps we should not look at stocks that drop much further into year-end, and start looking for stocks prevented from recovering because of tax loss selling.

In reality, everyone and their dog has already figured out this strategy's timing. Buyers are already acquiring their positions well before year-end, anticipating the January Effect rally, even while some shareholders continue selling to realize their tax loss.

Unfortunately, there is no index or indicator that discloses what may be motivating a sale - whether it is for tax purposes, investment reasons, impatience, child's braces, etc. We can take out some of the guesswork by limiting our choices to stocks that already stopped declining, or else those that are trying to bottom. I like to see price momentum indicators like MACD & RSI giving buy signals, and I also like to see Money Flow indicators under accumulation.

Even if all systems say "go," the actual impact of the January Effect rally should subside by month-end. Stocks that don't seem interested in the Effect right away probably won't be. And stocks that do very well into February are probably improving at the underlying company level, as well.

[Please note that none of the preceding is intended as tax advice, and that a qualified tax expert should be consulted for each individual's own situation.]


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