correction or bear market: where are we now?

correction vs. bear market

The financial media, in a deceptively over-precise way, has come to define a correction as a 10% fall in price of a given index during an ongoing bull market.  The same source defines a bear market as a fall of 20% or more.  There is some sense to making the distinction in this way, at least in that it’s unlikely that a market can fall by 20% and still be said to be retaining its fundamentally upward direction.  Other than that, I don’t find the 10%/20% distinction useful.

two worries:  price and earnings

To my mind, the key difference between the two–correction and bear market–is whether the favorable environment of expanding economies and resulting rising earnings per share which supports a bull market remains intact.

In a correction, stock prices have run ahead of the fundamentals and become too pricey.  We can no longer envision, say, achieving a 10% return from holding stocks for the coming 12 months.  Therefore, stocks have to fall to a level where buyers will anticipate a suitable return and reenter the market.  Buyers are concerned about price, not about earnings.

A bear market has very little to do with the 20% number.  What creates a bear market, simply put, is anticipation of recession, and the decline in corporate earnings that goes along with it.  Buyers don’t reenter the market after an initial fall, because they no longer believe that earnings will be rising.  They either continually withdraw funds from the  market or simply hold on to what they have and wait.  They look for some sign that the economic downturn the stock market has been forecasting has emerged—and reached its low point.  Historically, the turning point has been when the monetary authority begins to adopt a more accommodative stance.  Occasionally, it’s the legislature that acts.  Sometimes, it’s less action than investor perception that the assets of publicly traded companies are at bargain basement prices regardless of the near-term economic situation.


A correction runs its course in a matter of weeks;  a garden-variety bear market lasts nine to twelve months.

Where are we now?

For the mining industry–metals and oil–the picture has deteriorated dramatically over the past year.  This isn’t because the overall macro environment has weakened.  It’s because of overcapacity that the industry, in its typical shoot-yourself-in-the-foot fashion, has itself created.  This unfavorable situation will take a turn for the better only when substantial capacity is taken off the market.  Last time this happened for metals, in the early 1980s, the downturn lasted a decade.

Mining, and mining-dependent economies, apart, I don’t see any signs of actual GDP decline.  Yes, China may be growing at 5% instead of 7%.  Maybe it’s even 2%.  But it’s still growing.

So my vote is for correction.

One caveat:  as I’ve mentioned before, early September is the time when mutual funds in the US begin to sell to adjust the level of the yearend profit distribution they are required by law to make to shareholders.  Some of this selling may have been preempted by August’s market decline.  But until we see what the mutual fund situation is this year, I don’t think there’ll be much market desire to push prices higher.

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.






returns: capital changes vs. total return

Happy New Year!!

Like a stock that’s gone ex-dividend, my mind has gone ex-thoughts on the final day of the year.  My family might contend that this is not as unusual as I want to make it out to be.  Whatever the case, I can always hope that, like dividends, my absent thoughts will show up in my account as credits in a day or two.

Anyway, this is the best I can come up with on a sleepy New Year’s Eve.

Through last Friday, the S&P 500 was up 14.07% for 2012, year to date, on a total return basis.  The index was up 12.52% on a capital changes basis.

The difference?

Total return includes dividend payments as part of the return.  Capital changes doesn’t.

In figuring out your performance against the index, the total return figure is the one to use.  Looking at standard reference sources, like your broker’s website or the financial news, however, the figure that gets the most prominence is the capital changes one.

There are two historical reasons for this:

–from the mid-1980s until very recently, US Baby Boomers, who have been a major force in the domestic stock market, have been pretty much exclusively interested in capital gains, not in dividend income. So they paid the highest prices for growth companies.   Firms risked being typecast as dowdy and unimaginative if they paid large dividends, so they didn’t.  The result is that the dividend yield on the S&P has been small, and easily ignored.  No longer, though.

–keeping track on a daily basis of inflows and outflows of funds, account by account, is necessary for an accurate total return performance calculation.  This was beyond the computer capabilities of the custodian banks I knew for a considerable portion of my professional career.  Easier to ignore than to spend the time and money to upgrade staff and computer systems–especially when the calculation didn’t make that much difference.

2012 (and beyond): a different story

Dividends are again a significant component of the total return on US stocks.

2012 has seen a significant number of companies declare large special dividends, making the difference between their stocks’ capital changes and total returns especially large.  Take WYNN, which I own, as an example:

Through last Friday, WYNN is just about unchanged, year to date, meaning a capital changes return of 0.  The company has paid out dividends of $10, an $8 special dividend + four quarterly $.50 dividends.  On a total return basis, then, the stock is up a bit over 9%.  Yes, still an underperformer–but not by the margin that just looking at the figures Yahoo or Google offer would suggest.

I’m not sure that 2013 will be a year to write home about as far as capital change in the S&P 500 is concerned (more about this when I post my strategy for 2013).  Despite the absence of a spate of special payouts, I think dividends will be at least as important to next year’s total returns as they have been in 2012.

See you next year!


why September’s such a bad month for stocks

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.

here’s why

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 tradesSo 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).

one caveat

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.

this year?

My guess is that tax selling season will be relatively mildThe 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.