Microsoft (NASDAQ:MSFT) has had an absolutely incredible year. Already one of the world’s most valuable companies at the start of 2019, Microsoft stock managed to tack on another 50%, adding hundreds of billions in additional market cap.
The company has been firing on all cylinders, including crushing rival Amazon (NASDAQ:AMZN) for a key multi-billion defense contract for cloud computing services. Under CEO Satya Nadella, Microsoft has enjoyed inspired leadership, and shareholders have enjoyed incredible prosperity.
Over the long-run, there should be more strong gains ahead. If you’re willing to hold through thick and thin, Microsoft should keep being good to you.
However, for folks worried about the next correction, there’s a good argument to be made for taking some profits on Microsoft within the next week. Here’s why.
The January Effect
There are two related stock market phenomena that could affect Microsoft soon. Both are related to the calendar. The first is that small-cap stocks tend to experience much of their annual gains in the month of January.
Back in 2006, a widely-cited research paper showed the data of just how well stocks do in January, and in particular, small-cap companies.
Oddly enough, this effect seemingly persists even to this day despite more folks knowing about it. It appears that some fund managers act irrationally at the end of the year.
In particular, they buy winners and dump losers to make it appear that their fund held better stock selections than it really did. Given the lower liquidity in small-caps, this forced selling of laggards causes prices to fall too far, and then they can rebound smartly in January.
There’s also the related matter of taxes. If you sell before the end of the year, you realize a capital gain in the current calendar year, and have to pay tax by April. However, if you wait until January to sell, you can push off the taxes until the following year. Time is money, and people make the obvious decision to delay their taxes for a year when they can.
Concerns About Microsoft in January
You can probably see how this matters to Microsoft. The stock has been a rocket in 2019, up 55% year-to-date and 70% off the December 2018 lows. For a couple more days, fund managers will keep plowing into the stock so they can show it on their year-end portfolio holdings list online and in their annual reports.
Come January, however, the tides will turn. Managers will have no incentive to keep rushing into the stock, in fact, they’ll start selling their big winners to move money into cheaper under-the-radar stocks such as small caps.
Meanwhile, the folks that have huge gains in Microsoft will start pounding the sell button once the new year starts. People that have waited patiently to lock in their profits can finally start trimming their positions in January without incurring a big near-term tax bill.
Throw in algorithmic trading, which tends to add to momentum trades in both directions, and Microsoft could slide quite a bit to start 2020 once the bots switch from buying to selling.
A Healthy Correction
Microsoft is now trading for 31x trailing and 25x forward earnings. Both readouts are near their highest levels in many years. And deservedly so.
The company’s transformation from a low-growth software licensing business to the cloud has been an absolute gold mine.
However, this valuation is likely to come back in at least a touch. Think about it: A 10% correction in Microsoft’s stock would only take shares back to where they were in October.
In fact, for most of the summer and fall, Microsoft traded around $135-$140 per share. If it dips back to there in early 2020, it’d allow investors to buy into Microsoft at a more reasonable 22-23x forward earnings.
The Bottom Line on Microsoft Stock
Less than two months ago, with Microsoft at $142, I said that it was a buy given its huge cloud win over Amazon. That was the right call. However, let’s not get ahead of ourselves.
The company’s stock is up another 10% since the beginning of November. That’s another $125 billion in added market cap in large part due to winning a $10 billion defense contract. It’s great that they got the business, but was it worth that much incrementally?
I’m bullish on the stock market for 2020, and ultimately Microsoft should trade higher with it. But we’re getting seriously overbought on both the stock market in general and Microsoft in particular. Don’t overstay your welcome on the Santa rally.
We could ring in the new year with a meaningful correction. In that case, you might be better off owning tech stocks that haven’t run up so much in 2019, like Google (NASDAQ:GOOGL) and Facebook (NASDAQ:FB). Or give these 10 small-cap stocks a look to try to profit off the January effect.
At the time of this writing, Ian Bezek owned FB stock. You can reach him on Twitter at irbezek.
