strategy for 2014: yearend tax selling

I won’t be writing my strategy thoughts for 2014 for a few weeks.  However, it’s not too early for all of us to be thinking seriously about yearend tax selling, both as a market phenomenon and as a part of our personal portfolio management.

A disclaimer before I begin:  I’m an investor, not a CPA.  To get all the ins and outs of the capital gains tax rules, read the appropriate IRS or other tax authority publications.

why it happens

For most taxable investors in the US and mo,st other areas I’m aware of, the tax year ends with the calendar year on December 31st.  (One major exception is mutual funds and ETFs.  Their tax years generally end on October 31st–giving them time to close their books and make required distributions to their customers–who must pay tax on these receipts–before 12/31).

Investment gains are taxable once they’re “realized,” i.e., once the investment is sold.  But tax is due only on the net gain–that is, after subtracting any realized investment losses–not the gross amount.

In an ideal world, we’d all be doing tax planning constantly.  The reality is different.  Professionals believe (correctly, in my view) that taxes aren’t the most important elements of portfolio construction, so sometimes, in my attention, they pay shockingly little attention.  The rest of us just wait around until the end of the tax year approaches.

the phenomenon

For taxable professionals, like insurance companies or banks, who hold “balanced” portfolios of several asset classes (stocks, bonds, alternatives), they’ll try to match sales of, say, money-losing bonds and money-making stocks so that the net effect is zero taxable income.

Or it may be that guidelines, either internal or regulatory, require them to prune large winning bets.  In that case, they’ll scour the rest of the portfolio for anything with a loss attached to it and heave that overboard–just to knock down the tax bill.

This all occurs in the six-week period from early November to mid-December.  Clunkers may be sold more aggressively but there’s also downward pressure on winners as well.

For individuals, the main focus of selling tends to be small-cap names that have performed poorly.  They tend not to be sold with a very light touch.  Instead, individuals typically dump them out without much/any regard for price–just to get rid of them.  This sets the stage for the “January effect” as these beaten up stocks rebound after the first of the new year.

taking advantage

If the advent of tax season isn’t the reason for doing some serious thinking about what positions we want to take into 2014, it can at least be the occasion for doing so.  For example, serial clunkers in our portfolios tend to find ways to make our eyes skip over them when we examine our holdings.  It’s much harder for them to hide when we’re specifically looking for red ink to make use of

Similarly, we all love our big winners.  But we also have to .remember that at some point the risk of holding a (for us) humongous position outweighs the possible future gains.  Yearend is a good time to consider whether to trim.  Don’t be like a hapless acquaintance during the internet bubble who rode JDS Uniphase from $ 3 to $1000 (a position of $100,000 to $30 million) …and back down again.  Think Mark Cuban instead.

A more aggressive tactic would be to shop around for rebound candidates among this year’s big losers.  They may be pushed down by, say, another 10% before the year is out as holders shove them out the door to take tax losses.  This is not my style, so I have no words of advice, other than that you better do your homework before taking the plunge.

“wash” sales

One more point:  You can sell a position that’s deep in the red to recognize the loss and then buy it back.  But the IRS says you have to wait 30 days before the buyback to be able to take the loss.

I’m not a fan of the tactic, although some people may be able to do this successfully.  For me, it would be perpetuating the delusion that I haven’t made a mistake.

tax selling in 2012; the result on the “January effect” in 2013

yearend tax selling

Yearend tax selling typically has a significant influence on the US stock market during the fourth quarter.  There are three categories of investors involved:

1.  mutual funds and ETFs  About 25 years ago, the IRS allowed mutual funds in the US to change their tax years from a calendar basis to a fiscal year ending in October.  This was to help accounting firms spread their auditing workload and thereby avoid errors.  Every mutual fund complex I know of jumped at the chance.

The result has been that since the late 1980s, tax selling by mutual funds has depressed stock prices during late September and early October rather than in December, as mutual funds sell to reorient their portfolios and to manage the size of their yearly distributions of realized profits.

a non-factor this year

Because mutual funds and ETFs can’t make distributions until they use up the huge tax losses generated by redemptions during the 2008-09 market swoon, yearend selling by funds has been a non-factor in the US stock market over the past several years.

2.  taxable institutional investors, like insurance companies.  A generation or more ago, these were the Wall Street behemoths.  Their tax years end in December.  No one really thinks too much about them anymore, because their effect on markets is usually dwarfed by the actions of mutual funds/ETFs.

This December, however, it looks to me as if they’ve been shifting their portfolios away from bonds and into stocks–and in large enough size to help offset the negative effect of individual investor selling of stocks.

These institutional investors, as well as the mutual funds/ETFs are out of the market this week.  Post-Christmas trading reflects the activity of individuals only.

3.  individuals

a.  the January effect.  This is the bounceback during the first two or three weeks of the new year of stocks that have been depressed by large-scale tax selling in December.  Historically, the January effect has been most pronounced in small-cap stocks trading at under $10 a share–the typical stomping grounds of inexperienced amateur speculators.

Because it’s concentrated in small speculative stocks, neither the selling in December nor the subsequent rise in January have much effect on the major averages.

b.  special for 2012: reaction to impending tax law changes

Although we still don’t know what the new tax rates will be on capital gains, they’re certain to be higher than they are now–probably a lot higher.  This consideration has turned yearend tax selling by individuals on its head.

Instead of selling losers in December and winners in January (recognizing gains in the following tax year), and instead of small cap relative weakness/large cap strength in December, we are seeing the reverse.

stock market implications

1.  If I’m right about December behavior, the January effect for 2013 should be a selloff in small-cap speculative losers, counteracted by a rise in blue chip large cap stocks that have been the target of December tax selling.  AAPL will be the litmus test for this, I think.

2.  The return of taxable institutions to the market in the new year, and the absence of tax selling pressure from individuals, should both be stabilizing influences on stocks in January.  Bonds may be a different story.  But stocks could do surprisingly well, absent further negative developments in Washington.

yearend tax selling

tax selling…

It’s a little late in the day to be writing about this topic, which is perhaps indicative of my ambivalent attitude toward the idea.

…by professionals

Professional portfolio managers, by and large, don’t pay much attention to tax selling, for several reasons:

–we’re trained to think that tax considerations are much less important than company fundamentals in making buy and sell decisions,

–many of the portfolios we manage are tax-exempt–in fact, clients sometimes stress to us that they’re indifferent about whether profits come as ordinary income or capital gains,

–company fundamentals are way more important

–most professionals spend all their time watching their clients’ money, not their own.

Tax considerations aren’t nothing, though.

Mutual fund managers have always got to keep an eye on the size of the profits they generate, since virtually all of the have to be distributed as taxable gains to their shareholders.  In addition, for many individuals, investment gains–either through their own active management or from distributions from mutual funds or ETFs can be a significant source of (taxable) income.  So they’ve got to be at least aware of how big that income is.

…for individuals like us

As an individual, I have four general thoughts:

1.  I live in a state, New Jersey, where the state taxes on investment gains are very high.  So I try–earlier than the last day of the year–to flatten my gains by taking losses.

2.  Combing the portfolio for losers forces me to consider carefully any security that is below my cost.  I often find that the process forces me to  recognize that the fundamentals of a given security are bad (we’re all good at deceiving ourselves in this regard).  So I end up selling for fundamental reasons.  The search for tax losses is only the occasion, or the trigger, for my sale.  In some cases, the loss can be an ego-saving excuse.  In my view, that’s the main value of the process.

3.  As peculiar as it sounds at first, a loss has a financial value for a taxable investor.  It’s the ability to shelter gains on other investments from taxes.  For a losing stock that has little purpose in a portfolio, recognizing that value sooner than later is probably wise.

4.  Not selling a stock because you have a big capital gain is an easy–but sometimes painful–mistake to make.  So I have to do a sanity check on winners, as well.

I have a friend who had a very large inherited position in GE when it was a $40+ stock in 2007.  At the time, I wasn’t a fan of GE.  I thought Jack Welch was a brilliant self-publicist who had convinced the financial press that hamburger was filet mignon and who had left Jeff Immelt a horrible mess to clean up.  My view of Mr. Welch hasn’t  changed; my respect for Mr. Immelt has grown.

My friend said she felt she couldn’t sell because she depended on the dividend income from the shares.  She also said she had a cost basis of only a couple of dollars, so taxes would take huge bite (25% or so) out of her capital.  Since then, however, GE slashed its quarterly payout from $.31 to $.10–it has just been raised to $.17–and the stock now sells for $18.

In hindsight, it would have been a lot better to at least diversify away from GE and pay the taxes.  (An unbelievably gutsy investor could have bought the stock back for less than $6 in early 2009, but stuff like that never happens in real life.)

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.