The April Effect

Roll out the barrel, we'll have a barrel of fun.
Roll out the barrel, we've got the blues on the run.
Zing boom tararrel, ring out a song of good cheer.
Now's the time to roll the barrel, for tax day's all here!

With April 15 still a ways off, I realize it's a little early to be talking taxes. Or too late, since the window for tax-loss selling slammed shut three weeks ago. But I've had a "Eureka!" moment, and feel compelled to share it with my fellow Foolish investors.

A pecuniary corollary
A couple of weeks ago, whilst researching a column exploring the zigs and zags of the market in 2005, I stumbled across a bit of trivia. You see, I was looking for stocks that had suffered significant declines in price during a short period of time. I hoped to confirm that an investor who refused to yield to panic, who held fast through the decline, would see his stocks ultimately rebound from their losses and move higher.

As it turned out, it wasn't at all difficult to find stocks that fit the pattern. They were scattered about like leaves on the lawn after a windstorm. But it's what I did not expect to find that I'm going to tell you about today: An awful lot of these leaves were shaken loose and piled up in the month of April.

Your favorite uncle
The reason, as you may have guessed by now, had something to do with taxes. Now, I've never really looked into the concept of an "April effect" on stock prices before. But others have. A 1987 article in the University of Chicago Press' Journal of Business observed that, for years, returns on the London Stock Exchange in April weren't particularly different from returns in other months. Subsequent to the imposition of a capital-gains tax, however, the British stock return data exhibited "apparent monthly effects" in April.

Completely by accident, I stumbled across some possible evidence of this effect in the U.S. markets. While looking for stocks that suffered short-term losses in 2005, I noticed that an awful lot of the declines occurred in April. Digging further, I learned that similar declines also took place in April 2004 -- but the "April effect" was almost entirely absent during the bull market year of 2003. To illustrate, here are 10 stocks that I researched in preparing the previous column, their returns in April 2005, and their returns in the same month for the previous two years:

Perhaps the most important piece of information was what happened subsequent to these April showers: The stocks proceeded to rise. As 2005 progressed, each of the above 10 stocks proceeded to make up all of its losses, and to end the year significantly higher than they had begun the month of April. On average, these stocks gained 16% from their April high to the present. Investors fortunate enough to catch them at their April lows could have reaped 32% gains.

Now, let me be clear: This is just a small sample and a far more rigorous statistical analysis would be required before we can confidently accept the reality of an "April effect" in the U.S. Because my research focused specifically upon stocks that suffered significant declines in 2005, my results might possibly be skewed through "research bias."

It's worth considering other factors that might factor into a hypothetical "April effect." For example:

• The obvious: Investors, strapped for cash on tax day, sold off some of their stocks to raise cash to pay Uncle Sam.
• The corollary: Investors -- seeing their stocks begin to fall in early April -- panicked and sold their shares through April 15 and beyond.
• The market timers. You've heard the old investing rhyme, "Sell in May and go away," right? Well, others have heard it, too. They know that you know. You know that they know. They know that you know that they know.. At some point, we all know that someone is going to cut in line and try to beat the rush by selling before May.

Eppur si muove
But what if I'm right and the April effect does exist? Why, then, it behooves a Fool to anticipate it and make the most of it in the months when it recurs. Mind you, I'm not advocating market timing here. I'm not saying "Sell everything on March 31, and buy it all back on May 1." The data from April 2003 should convince you of the recklessness of such a move. But if, come April 2006, you happen to see the stocks of high-quality companies with sound fundamentals begin to wobble and fall for no particular reason, I suspect that might be an excellent time to buy a few extra shares for your portfolio.

Then what are you advising?
One of the themes we harp on again and again at Motley Fool Stock Advisor is taking advantage of market pullbacks -- just like the ones that tend to crop up in April. Fools don't invest all their money in one fell swoop and then call it quits. We save money constantly. We invest regularly. Like Fool hero Shelby Davis, the former government clerk who turned $50,000 into $900 million over a lifetime of patient investing, we believe that "the best time to invest is when you have the money."

When combined with our portfolio's market-crushing 63% to 19% margin of victory over the S&P 500, investing "whenever you have the money" can put any Fool on the path to wealth. If Uncle Sam wants to push stock prices down so you can buy cheaper in April, it seems to me the polite thing to do is say "thank you," and take the free money. Oh, and speaking of "free," did I mention you can take Stock Advisor for a spin free of charge, just by clicking here?

Editor's Note: The hypothesis of an "April effect" is just one Fool's idea. Presently, there isn't persuasive scholarly evidence supporting such an effect for U.S. stocks.

Home Depot is an Inside Value recommendation, and eBay is a Stock Advisor pick. Fool contributor Rich Smith has no position in any company mentioned in this article. The Motley Fool's disclosure policy has no rivals.