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The Trump rally may be getting an artificial boost that could end abruptly in January

A year-end stock market phenomenon is getting turned on its head by the election of Donald Trump and that could be artificially boosting the stock market.

Some traders worry the market party may end the first trading day of the new year because of this twist.

In December, especially during the first half of the month, investors often take profits on their stock winners in order to lock in their capital gains taxes for the year. But with the prospect of a lower capital gains rate in 2017 made into law by Trump and a Republican-led Congress, investors may be delaying that selling.

"We would not be surprised if investors are waiting until next year to realize their gains," Dan Clifton of Strategas Research Partners wrote in a note this week. "Republicans are proposing to lower the capital gains and dividend taxes from 23.8 to 20 percent as part of Obamacare repeal and again cut the tax to a 16.5 percent rate as part of tax reform."

Check out this chart from Bespoke Investment Group showing the average intraday performance during the month of December the last 30 years and during the current bull market.


Source: Bespoke Investment Group

One can see the clear weakness that comes into the market mid-December, especially during bull markets when there are more capital gains taken because a greater amount of stocks are higher for the year.

But that hasn't happened this year. The S&P 500 is up 2.9 percent in December through Thursday, bringing its total postelection gain to 5.7 percent.

Brian Kelly of BKCM sent a note on Dec. 1 to clients predicting this could take place.

"There are certainly some hurdles to a massive tax code overhaul, but [it's] clear that taxes next year will be no worse than this year, so it behooves investors to wait for 2017 to take profits. Despite the enormous move since the election, this simple insight could be the fuel for a sustained year-end rally in stocks. If the majority of investors also decide not to take profits this year then the supply of equities for sale could be reduced. At the same time that supply is constrained, the demand for US equities continues to rise — especially from those who may have missed the rally."

In a phenomenon called the "January Effect," the tax-related selling in December would often lead to gains in January as investors buy back stocks that they sold for tax reasons. Market pundits believe the effect is even stronger for small cap stocks because they have a greater proportion of retail investor ownership.

Because of Trump, there should be no significant "January Effect" lift to the market next month. What's more, some traders worry there's a chance that investors delaying their selling will dump stock the first chance they get in January to lock in that new Trump 16.5 percent capital gains tax rate for 2017.

That could be a mistake though, according to Strategas' Clifton.

"In 2003, when Congress cut the capital gains tax, the provision was made retroactive to the first committee hearing in March. So be careful just selling on January 1st, depending on when Congress acts, the provision may not be in effect at the exact start of 2017," he wrote.

So it all depends on whether investors dump their stock on Jan. 3 or delay taking capital gains even further in order to get clarity on when the new tax rates take effect. Their decision could determine the fate of this short-term Trump rally.