Tax Loss Selling, Window Dressing & The January Effect in 2023
Extreme Return Dispersion in 2022
2022 has been a very bad year for the stock market. The S&P 500 is down -20%, the Nasdaq is down even -34%. Almost three years after the outbreak of Covid-19, the Nasdaq now trades merely 5% above its pre-Covid high - as if the acceleration of digitalization, three years of compounding, and some 16% cumulative nominal price inflation based on the CPI never happened. On the other hand, the Dow Jones is only down 3.5% as old school stocks like Coca Cola and Mc Donalds still trade at PE ratios above 25. Instead of fancy break-through technologies, oil and gas stocks are the 2022 darlings of the global investment community.
Yet, the 30% underperformance of the Nasdaq relative to the Dow Jones does not even tell half the story about the destruction that has happened to tech stocks. Cathy Wood’s ARK Innovation ETF is down 69%(!) and countless “profitless growth” stocks like Carvana are down more than 90%, effectively priced like bankruptcy is imminent.
Inflation and the FED
The key reason cited for this seismic shift in the investing landscape is the FED and its hawkish interest rate policy. The FED funds rate is approaching 5% and Jerome Powell repeatedly signaled his firm intention to keep interest rates at this level throughout 2023.
However, it is becoming increasingly clear that the FED has already more than achieved its goals. The CPI ex shelter has clearly peaked in June 2022 and is now down 0.8% cumulatively for the second half of the year.
Shelter makes up about 35% of the CPI basket and is measured in a notoriously lagged by circa 12 months. However, housing prices have actually also peaked in June and are down 3% nationwide based on the Case / Shiller home price index. Even rents are increasingly falling month after month: Redfin’s median asking rent is down 1.6% since August. Taken together, the actual real time deflation since June is rather 1.2% or 2.4% on an annualized basis.
It is therefore not surprising that the critics of the FED’s ultra-hawkish interest rate policy are getting louder and larger in number. Jeremy Siegel and Elon Musk are warning repeatedly warning that the FED is committing a serious policy mistake.
History has shown over and over again that the FED always talks hard, is mostly late, but will eventually bend to the data. Contrary to the FED’s interest rate projection for 2023, I expect a significant pivot in 2023. Official CPI inflation will continue to fall off a cliff. However, by the time the official CPI shows the desired ~2% inflation rate, we would already be in way more severe deflation based on real time data. Hence, I expect the FED will start to significantly decrease the FED funds rate no later than Q2.
The current market consensus on the other hand seems to be that we are in a new era of high interest rates. A regime shift, as a result of which growth stocks will be “dead money” for years to come. I couldn`t disagree more. I expect a fast return to low CPI inflation and hence a normalization of interest rates. If true, growth stocks are set up to experience a strong recovery in 2023.
However, we are not quite there yet. As I am writing these sentences, the Nasdaq has lost 7% just in the month of December and ARK’s Innovation ETF has lost even 14%.
What was driving this further massive drawdown at the end of a very bad year? In the end, December revealed no new fundamentals after the earnings season. Oh, and there was another significant “inflation miss”, before the FED to chose to ignore it once again and stubbornly execute on its “mission.”
Tax Loss Selling & Window Dressing
I suspect tax loss selling and window dressing are the name of the game that has been driving another huge drawdown at the end of a very bad year.
Tax-loss selling occurs as investors realize a capital loss on a losing position in order to offset capital gains realized in other positions. Given the extreme losses in many growth stocks, there is an enormous potential for tax loss selling at the end of 2022. According to the wash-sale rule, investors must wait 31 days before repurchasing these positions. If an investor wanted to buy back the positions in January, any sales had to be done no later than December.
Window-dressing is a strategy by fund managers to improve the appearance of their portfolios before presenting to clients. Who in their right mind would show a top five position in a stock that is down 90% year to date? To show what a poor fund manager you are? In order to not even have to discuss about the painful experience with the stock, the obvious decision is to get rid of the position before the end of Q4 (and realize some tax losses).
I don`t think there has been any year where the incentives for tax loss selling and window dressing have been as strong as in December 2022. In fact, these incentives may be so strong that professional investors would still choose to sell positions they fundamentally believe in.
At the end of 2022, many of the strongest companies in the world are now trading cheap as never before:
But what next: Do these companies potentially still have a future? Now this is where it gets interesting for January 2023.
Revival of the January Effect in 2023?
December 2023 looked like nothing but a capitulation in growth stocks. Capitulation is often corresponding with the actual bottom of a market crash. However, if investors have not totally given up on growth stocks, they will eventually buy them again.
Maybe its not the worst of ideas to buy them (back) in January? In the end, inflation is falling off a cliff, forcing the FED to pivot sooner rather than later, and some of the world’s strongest companies are as cheap as never before. Fund managers now afraid of having to write about failures in Q4 2022, can then brag in their 2023 Q1 letters about how smart they were to load up on growth stocks early in the year.
It can`t be that obvious, can it?