Okay?

So let's actually look at how these tax rules have changed,

which really provides identification strategy to see, do tax rules

in the US actually affect asset prices and stock returns around the years?

So three tax regimes here.

And the key thing to focus on across these tax regimes is,

what is the holding period to classify for short term versus long term status here?

And both regime I and regime II, only a six month holding period for short term.

If you held the stock beyond six months, it classifies for long term tax treatment.

So the current rule in the US in which we had kind of in some years prior,

was a 12 month holding period.

So you could see there's variation over time, whether the holding period for

short term versus long term is six months versus 12 months.

Why does that matter?

Well we know if you realized a loss within the short term window

you're going to get a higher tax benefit.

Because short term gains and losses are at a higher rate than long term gains or

losses.

If you want to get a tax deduction you want the tax deduction

at a higher higher tax rate.

Okay?

So changes in this holding period of short term status are maybe potentially useful,

and maybe what suggest differences in

January returns associated with those changes in the tax rules.

Okay?

So what do we do in this paper?

We relate the January returns of stocks to the return over

the prior January to June and prior July to December.

And you can see this is getting at prior six months or prior 12 months here.

When the short-term holding period is defined as only 6 months,

returns over the prior July to December should matter

most in predicting December selling and the subsequent January return.

Right? Because that short term status gives you

a higher value for the tax deduction.

Higher value to realizing the loss.

When the short-term holding period is defined as 12 months,

returns over both the prior July to December and January to

June should matter in predicting December selling and the subsequent January return.

So just think simply if you bought an asset in February of 2014,

once you get to the end of 2014, if it's a one year holding period for

long-term status, it's still a short term asset, whether have that one year cutoff.

If it's a six month difference, short term versus long-term,

if you bought the asset in February of 2014,

by the time you get to the end of 2014 six months has already passed,

it's already a long-term asset, so there's less value to realizing the loss.

And that's what we're exploiting here in this empirical analysis.

So key is, under the window-dressing story, changes in tax rules for

individuals shouldn't matter in predicting the January return.

Okay? Because institutional investors is just

like we want to sell stocks that have prior losses, because

you don't want to be seen as holding them when we file our annual report.

So let's relate January returns to past performance.

And we're going to do a simple regression where we look at what's the January return

during the first week in January,

and we'll also throw in this kind of last day in December as well.

Because there's some evidence of like, hey, the kind of January rebound

seems to start the last day of December but that's a kind of minor point.

Same results will hold if we just look at the first five days in January.

So look at this first week in January return and relate it to,

what was the performance of the stock in the past January to June period?

As well as the past July to December period?

And when we're looking at these kind of losses, that is just giving us,

what was the magnitude of the loss?

And that is something that's going to be negative, so if the loss was,

it fell 10% then this is going to be minus point one.

If the stock went up then the loss is 0.

Okay?

So let's look at the results over these three tax regimes.

And if you see these three stars,

it indicates statistical significance at the 1% level.

So what do we see for both tax regime I and tax regime II?

We see if you have losses during the past July to December,

you see those losses predict a higher January return.

So the way to think about this is if you have a loss through the prior July to

December of ten percentage points, that predicts a higher January return of 1.4 or

1.5 percentage points across these two regimes.

What's interesting is the effect of a loss in July to December

is higher than the effect of a loss from January to June.

You look at the coefficient loss July to December, it's always higher and

statistically higher in magnitude then the coefficient on the loss January to June.

Both in regime I.

And in Regime II.

Why is that the case?

Short-term losses are more valuable in terms of reducing taxes.

Over Tax Regime I and Regime II, it's only a six month holding period for short-term.

After six months, it becomes long term.

So losses that would've happened at the beginning of the year, January to June by

the time you get to the end of the year, those holding would've been long term.

So, they should matter less in December selling and thus, a January rebound.

So, the kind of key prediction here for Tax Regime I and

Tax Regime II losses at the end of the year.

Remember, a losses are negative.

Negative times a negative is a positive should lead to higher January returns

than losses that happened at the first part of the year.

Exactly what we find, but

what happens when you go to Tax Regime III when it's a 12-month holding period?

So, then losses in the first half of the year and

the second half of the year should matter in predicting the January return.

If I bought the stock in February, once I get to December,

that would still be a short-term holding, because a full year hasn't passed.

What do you see for these coefficients here?

They're basically statistically the same.

So when the tax regime is 12 months, losses during the first half of the year,

January through June losses during the second half of the year.

July through December both matter in the same way in predicting

the subsequent January affect.

So I think this is quite compelling evidence that the changes in the tax rule

seem to affect the January returns and

that suggests that the individual tax laws actually affect asset prices,

and returns around the end of the year.

So now, it's time to bring out for our pause, think and answer segment here.

So, two questions.

Why has the small-firm January effect declined over time?

We saw relative to the full sample since the early 80s,

the small-firm effect has declined over time and second question here.

Assuming the January effect persists,

what type of investor should be buying loser small stocks in December?

So, let's think about each of these two questions and then we'll come back for

my take on them.