a Fall stock market swoon?

Over the past thirty years, the US stock market has tended to sell off from late September through mid-October, before recovering in November.  That historical pattern has some brokerage strategists predicting a similar outcome for this fall.

Why the annual selloff?

It has to do with the legal structure of mutual funds/ETFs and the fact that virtually all mutual funds and ETFs end their tax year in October.

1.  Mutual funds are a special type of corporation.  They’re exempt from income tax on any profits they may achieve.  In return for this tax benefit, they are required to limit their activities to portfolio investing and to distribute any investment gains as dividends to shareholders (so the IRS can collect income tax from shareholders on the distributions).

2.  All the mutual funds and ETFs I know of end their fiscal years in October.  This gives their accountants time to get the books in order and to make required distributions before the end of the calendar year.

3.  For some reason that escapes me, shareholders seem to want an annual distribution–even though they have to pay tax on it–and regard the payout as a sign of investment success.  Normally management companies target a distribution level at, say, 3% of assets.  (Just about everyone elects to have the distribution automatically reinvested in the fund/ETF, so this is all about symbolism.)

4.  The result of all this is that:

a.  if realized gains in a given year are very large, the fund manager sells positions with losses to reduce the distribution size.

b.  If realized gains are small, the manager sells winners to make the distribution larger.

c.  Because it’s yearend, managers typically take a hard look at their portfolios and sell clunkers they don’t want to take into the following year.

In sum, the approach of the yearend on Halloween triggers a lot of selling, most of it tax-related.

not so much recently

That’s because large-scale panicky selling at the bottom of the market in early 2009 (of positions built up at much higher prices in 2007-07) created mammoth tax losses for most mutual funds/ETFs continue to carry on the books.  At some point, these losses will either be used up as offsets to realized gains, or they’ll expire.

Until then, their presence will prevent funds/STFs from making distributions.  Therefore, all the usual seasonal selling won’t happen.

how do we stand in 2014?

I’m not sure.  My sense, though, is that the fund industry still has plenty of accumulated losses to work off.  As a general rule, no-load funds have bigger accumulated unrealized losses than load funds;  ETFs have more than mutual funds, because of their shorter history.

This would imply that there won’t be an October selloff in 2014.

Even if I’m wrong, the important tactical point to remember is that the selling dries up by October 15 -20.  Buying begins again in the new fical year in November.






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