The January Effect Won't Save You

Stock investors have seen little but losses in recent months. But if you're looking forward to the New Year to bring your portfolio a much-needed relief rally, prepare to be disappointed.

Back in July, I suggested that if you were planning to sell some stocks in order to take tax losses, you might want to do it sooner than later. With the S&P 500 already down around 14% for the year at that point, the idea was that by getting an early start, you'd get a much better deal than those who waited until October or November to think about tax-selling. Conversely, if you wanted to buy stocks, the tax-selling argument supported waiting until later in the year, after other investors had taken their losses.

As it turned out, that was a good call -- but not necessarily for the right reason. And because of potentially large losses and their resulting tax consequences, the January jump that often follows the end of tax-selling season might not materialize -- if it doesn't turn into even more selling.

Not a fortune teller
Of course, I had no idea last July just how badly the stock market would suffer between then and now. An update on the stocks from that article tells the whole story:

Source: Yahoo! Finance.

Those who had the patience to wait for better bargains turned out to be almost prescient, as the S&P 500 has fallen another 30% since early July. Now, investors have more losses than they know what to do with.

Winning with losses
The glut of capital losses in investors' portfolios has created another problem for the stock market. Typically, investors take advantage of tax-selling opportunities near year's end in order to offset gains in their portfolios. That helps them save money on their tax bill; if they didn't take those losses, they'd have substantial income tax liability -- as much as 35% on stocks held for a year or less, and 15% on their long-term gains.

But with the markets as bad as they've been in 2008, you may well have seen gains on your longest-held stocks disappear. Since investors can only use an additional $3,000 to offset their other income, there's no urgency to sell any more stocks right now for tax purposes.

But wait until 2009
Next year, though, you may have more incentive to lock in some tax losses. Here are some of the reasons why:

• The $3,000 cap on using capital losses against ordinary income hasn't increased in years. Although Sen. McCain proposed raising the limit to $15,000 or more during the presidential campaign, President-elect Obama could include a similar measure in his proposed tax legislation to help middle-class taxpayers with big losses.
• Speculation about whether the new administration will raise capital gains rates in 2009 hasn't led to any definite conclusions. But the possibility of an increase in the current 15% maximum rate would make capital losses more valuable in offsetting gains next year.
• Those who have long-term gains this year might prefer to pay the preferential tax rate now, even if they have short-term losses they could use. Using those losses next year to offset short-term gains in 2009 would save them more in the end.

If all these factors have investors primed to sell as 2009 begins, January could look like just a continuation of 2008's dour market trend, rather than the beginning of the recovery so many have waited for.

Of course, markets rise and fall for many reasons that have nothing to do with tax strategy. But in a market environment where everything has seemed to go badly for stocks, this is just one more black mark that could get 2009 started off on the wrong foot.

More on what the future will bring:

• The best stocks for 2009.
• What the market's biggest fear is for next year.
• How to make more money from your investments.