April is the cruelest month

T.S. Eliot inadvertently described our current market in the first line of “The Waste Land”, as the past few sessions have reminded traders yet again of the market’s fickle nature. In most years April is normally a good month to be fully invested, especially as stragglers top off their IRA contributions early in the month. This year we may be seeing the opposite, as investors race to sell their winners to raise money to pay taxes.

Pinning down individual investor behavior on a collective basis can be very difficult, but as I received numerous calls over the past few days about the underperformance of the so-called momentum stocks, I have become increasingly convinced that tax selling is likely a factor in those stocks’ declines. 

The rationale is this: 2013 was a very good year for most investors, and active investors would likely have found themselves with a series of short and long term gains, and thus a hefty tax bill due next week. If those investors remained fully invested in the market, using margin to trade the momentum stocks, they would need to sell some of their holdings to pay the IRS. As the stocks began to decline last week with the first wave of taxable sellers, the selling continued, fuelled by fears of margin calls, and the recent rout was on.

Though this is a theory that I can’t prove directly, because market moves are initiated by the activities of the marginal buyers or sellers, it is important to search for catalysts that would initiate changes in investor behavior. If the selling is indeed tax-related, it would indicate that the decision about buying the dip may be a matter of timing as much as pricing.

About the Author

Steve Sosnick is an Equity Risk Manager for Interactive Brokers.

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