October could be a tricky month–but for unusual reasons

October selling

Seasonal weakness usually hits the US equity market in late September and continues through the first half of October.  The reason is tax selling by mutual funds and, to a much lesser degree, ETFs.

mutual fund/ETF tax planning

A mutual fund or an ETF is a special kind of  corporation that is exempt from income tax on any profits it makes, provided that it sticks to portfolio investing and distributes to shareholders basically all realized gains.  These payouts become taxable income to their recipients.

For every mutual fund or ETF I know, the fiscal year ends on Halloween.  That’s when the fund has to figure out its gains and make the required distributions.  This has nothing to do with trick or treating.  It’s October so the fund can close its books and send out the distributions before December.

Funds typically begin to prepare for their yearend in late September.  They either sell winners so they can make a distribution (for some reason, shareholders regard distributions as a good thing), or they sell losers, to use the tax losses this creates and to keep the distribution down to a reasonable size.

Not this year, though.  In fact, not since 2009.  As far as I can see, most mutual funds/ETFs still have considerable accumulated tax losses on their balance sheets.  Those resulted from the massive panic-induced redemptions that occurred at or near the bottom of the market in early 2009.  The losses, which offset realized gains, will swamp any profits funds may have made this year.  So there’s no point to doing normal year-end tax selling until past years’ accumulated losses are either used up or expire.

this year’s issue is different

It’s budget negotiations in Congress.

spending power

One negotiation, whose deadline for action is tonight, is over Congress giving the administration authorization to spend money to run the Federal government.  Talks are deadlocked.  Absent a last-minute compromise, an estimated 800,000-1,000,000 government workers will be furloughed effective tomorrow.  That’s out of 2.1 million Federal employees.

The furloughs would add about .6% to unemployment in the US.  They would also have negative economic ripple effects, as corporations that do business with Washington defer spending plans while they wait for the situation to develop.

According to USA Todaythe Federal government has shut down 17 times since 1977, though usually only for very short periods of time.

borrowing power

The second, and more important, negotiation is on raising the Federal debt ceiling.

Washington currently borrows about 20¢ of every dollar it spends.  The Treasury estimates it will reach the limit of its current borrowing authority from Congress in mid-October.  Without an increase, the government will be reduced to spending only money that comes in the door from taxes and other payments.

At some point, it’s possible that the Treasury wouldn’t have enough money on hand to make interest payments on the Federal debt or redeem Treasury securities that come due–meaning the US would be forced to default on its debt.  That would be awful.

Wall Street worries

I don’t think Wall Street–and any other world stock market–will find it easy to move up during a period of uncertainty like this one.

The main issue, of course, isn’t the looming government shutdown.  The longest happened during the Clinton administration–twice.  The S&P fell modestly, and quickly regained lost ground after the shutdowns ended.

It’s the question of whether the crazy behavior of Congress in causing the shutdown will be repeated in the debt ceiling talks, where the stakes are much higher.

Personally, I can’t decide whether the Tea Party Republicans who are at the core of the disputes are content to bring the government to edge of disaster before compromising, or whether they want to go further.  After all, in March 2009, a group of similar-minded Republicans voted against the bank bailout, saying they would prefer a repeat of the Great Depression of the 1930s to pumping money into bankrupt financial institutions.  The S&P fell by 7% on that news.  Then the Republicans changed their minds.

That was a great buying opportunity for stocks.  Hopefully, we won’t have another one.  But uncertainty will likely keep a lid on the market until the debt ceiling issue is settled.

what I’m doing

From a strategic point of view, I think the best course is to believe that politics will eventually work itself out and to not change portfolio positioning.

My tactical view is a little different.

In times like this, short-term traders tend to argue that if the market can’t go up, there’s only one direction it can move in.  So the lack of upward potential implies downside pressure.

That make me a buyer on weakness.

Leave a Reply

%d bloggers like this: