welcome to September 2011
This year, September has opened to a mini-swoon in world stock markets caused by a poor jobs report in the US, worries about the government suing banks over past sub-prime mortgage sins, and general panic about Greece (the EU political “plan,” if you’d call it that, appears to be to let the situation deteriorate to the point that voters will be grateful for even a painful rescue and not kick out the politicians who caused the problem in the first place).
the annual September equity decline
Who knows how long this downdraft will last–as I’m writing this, global equities appear to be rallying a bit, but this isn’t the normal seasonal decline in stocks.
It’s really not just September when stocks go down, either. There’s a several-week period of selling that typically starts each year in mid-September and ends in mid-October. But there’s usually a rally toward the end of October, so the early-month decline is less obvious.
This decline has nothing to do with the macroeconomy or stock valuation. It’s all about mutual fund taxes.
Mutual funds in the US (ETFs, too) are a special type of corporation. Their activities are limited to investing, and they’re required to distribute to shareholders virtually all of their net realized profits soon after the end of each tax year. In return for these restrictions, they’re exempt from corporate tax on their gains. Only shareholders pay.
The tax year for virtually all mutual funds, which determines how much they must distribute, ends on October 31st.
adjusting the distribution
Shareholders like to get a distribution, which they take to be a sign that things are going well. This makes no sense to me–better to “ride your winners” and let gains compound without paying tax–but that’s what the customers want.
On the other hand, people don’t like to pay taxes, so they don’t want a gigantic distribution (over 5% of the fund’s assets), either.
So mutual fund managers start to adjust the size of their potential distributions sometime in September.
This involves a lot of selling.
If the required distribution is too big, a manager will scour his portfolio for stocks where he has a loss that he can sell. If there’s no distribution, or if the payout will be too small, he hunts around for positions where he can justify taking a partial profit.
It’s not about actually sending money to shareholders,
as I’ve heard “experts” on finance talk shows say. An overwhelming majority of mutual fund shares, say, 95%+, sign up for automatic reinvestment of distributions. So if the yearend gains add up to 5% of the fund assets, the amount of money that actually leaves the fund is .05 x .05 = .0025, or .25% of the assets. That’s far less than the frictional cash a manager needs to have on hand to ensure smooth settlement of trades. So the transfer of funds is not a big deal.
this tax planning is healthy, in my view
It gives a reason for a manager to step back and take a hard look at all the fund’s positions. It also gives him a psychological excuse to dump out stocks where he’s hoping against hope that they’ll work out (trust me, even the top managers have one or two of them).
If a fund has unused tax losses left over from prior years–and many still have them as scars from panic redemptions by shareholders in late 2008-early 2009–it can’t make a distribution until those losses are gone. Either the fund makes offsetting gains (which won’t be subject to tax–a good thing) or the losses expire.
In either case, there’s no need to take part in the yearly September-October tax selling ritual.
My guess is that tax selling season will be relatively mild. The S&P 500 is showing about a 1% loss since last Halloween. So unless a manager made very large adjustments to his portfolio positioning a few months ago, when stocks were considerably higher, the gains generated in day-to-day portfolio activity shouldn’t be large. Also, at least some funds will continue to be in a net loss position, so they won’t be able to make distributions no matter what.
This bodes well for a floor in the shareprice of the major Blue Chips and even substandard stocks. I don’t see a substantial selling into October. Because the October crash won’t self fulfill, the following years Octber will be mild events. The charts will be bullish for many years to come.
Like Japan, a low interest environment will show a sideways and gradual inflation of stock prices.