While taxpayers may have to dig deep to pay off Uncle Sam during tax season, it’s not just them who will bear the brunt of thinner wallets. The stock market is also feeling the pressure, as many taxpayers are liquidating stocks and money market funds to meet immediate cash needs. This effect can put pressure on stock and bond markets in several ways, at least in the short term.
Here are some key ways tax season affects the investment markets.
Money flows out of the market during tax season
The first two weeks of April can be a bit rougher for the market than normal. According to data analytics firm Kensho, the Standard & Poor’s 500 Index fell an average of 0.2 percent between 2000 and 2016. And the odds of it rising – by 41 percent – were much worse than a coin flip.
Tax season can affect the markets in a number of important ways, which are believed to be related to taxpayers raising cash to pay off their debts:
- Investors are liquidating stocks and funds, including those that invest in short-term debt
- As investors liquidate, the price of stocks and bonds may fall
When taxpayers need to come up with cash to pay their tax bills, they will often rely on bank accounts or money stashed in money market funds. Money market funds are mutual funds that hold safe, short-term bonds issued by the U.S. government and corporations. They are a cash equivalent with low risk, high returns and highly liquid, making them attractive to investors.
In the short term, a decrease in liquidity puts downward pressure on these funds and the assets they hold. If there is less demand for these bonds, their price may fall. As prices fall, their returns necessarily rise, because they continue to offer the same total payout but are cheaper.
So if liquidity leaves the market to pay tax bills, asset prices may fall as a result. And it may not just be these specific assets that feel the effects. The effects could be broader, especially after a strong market run – such as in 2023 – when investors realize gains on well-performing stocks.
However, this trend can be difficult to detect at any time because the market is forward-looking and can start pricing in the impact of tax sales weeks or months before they actually occur.
The market tends to recover later in April
Despite (or perhaps because of) the poor performance in the first half of April, the second half of the month is performing relatively well, Kensho said. After tax day, the S&P 500 rallied to finish the month higher on average about 1.7 percent an astounding 75 percent of the time, again based on the 2000-2016 time frame.
The expectation of a tax-related market decline can be as powerful as any actual taxpayer-related sale to meet its obligations. Traders may realize that they can take advantage of these expectations by buying earlier during any weakness and selling later in the month.
While the second half of April may be strong, the following six months have historically often been the weaker part of the year. This trend is part of what’s known as the ‘Halloween effect’, with the six months after Halloween – November 1 to April 30 – seeing particularly strong gains.
The S&P 500 rose about 5.3 percent from November to April, compared with a 2.4 percent gain from May to October, 1928 to September 2023, according to Yardeni Research.
How should investors react to this effect?
The overall effect in April is small, so investors are best served by sticking to their long-term plan. Over time, the S&P 500 has delivered annual gains of about 10 percent, so it makes sense for investors to give their money more time in the market rather than trying to be a trader. As the old market mantra goes, “Time in the market is more important than timing the market.”
For investors, a long-term approach means continuing to contribute to tax-advantaged retirement accounts such as 401(k) plans and IRAs. Invest regularly and hold on, and your returns will resemble those of the index. Try to dip in and out of the market, and you could seriously underperform.
It’s easy to buy S&P 500 index funds, and the best ETF brokers offer them. And they are a great investment for both beginners and advanced investors. Beginners can get started investing and earn attractive long-term returns without having to know much about investing.
Of course, if you notice some market weakness in early April and want to add a little extra to your mutual fund during a dip, it may be worth doing so, but maintain discipline over the long term.
In short
The effect of tax season on the market is an interesting anomaly, but for long-term investors it is essentially a non-event as they focus not on next week or next year, but on more distant futures.
