Submitted by Nicholas Colas of DataTrek Research
Even with Wednesday’s rally, December’s 11-13% declines (S&P 500, Russell 2000) for US stocks couldn’t have come at a worse time for markets. First, there is the psychological damage of seeing such a swoon in what is a typically good month for domestic equities. Then there is the magnitude of the decline, erasing solid YTD gains in just a few weeks and making 2018 the first down year for US stocks since the Financial Crisis a decade ago.
One underappreciated problem, however, (unless you happen to manage taxable portfolios) is how money managers and investment advisors had to respond to this sudden reversal of fortune. Put yourself into their shoes for a moment:
- In a few days your clients will see a year-end statement with declining bond, stock, and commodity asset prices. Pretty much nothing worked this year… That will sting, but after a decade of gains that is a manageable issue.
- But… Say you sold some large winners earlier this year as stocks began to roll over, perhaps the large cap Tech names that everyone from hedge funds to retail investors over-weighted until recently. Those were good sales, to be sure, but in a taxable account they create a future liability and your clients will have to cut a large check to the US Treasury in April 2019.
- To minimize the tax bill from those capital gains, you need to sell some losers to offset those winners. Clients understand market-to-market losses; they can be less forgiving, however, of out-of-pocket tax payments when there is no wealth effect of rising asset prices to soften the blow. Until September, those paper gains were there. Now, they aren’t.
Here is the real-world market impact of that problem. Back on December 17th we gave you a list of the 11 worst performing names in the S&P for the then-YTD. This basket shows that tax loss selling is very much in play at the single-stock level just now. Consider:
- The names we highlighted as the biggest S&P 500 losers YTD: General Electric (GE), Mohawk (MHK), Newfield (NFX), Affiliated Managers (AMG), Invesco (IVZ), Western Digital (WDC), L Brands (LB), Alcoa (AA), Unum (UNM), Brighthouse Financial (BHF), and IPG Photonics (IPGP).
- From the last day of November to December 24th, the average decline for these 11 names was 21.1%. Excluding GE, which was only down 7.5% over the period after a drubbing through much of 2018, the average decline of the remaining 10 names was 22.6%.
- This group’s performance was much worse than either the S&P 500 or Russell 2000 over the same period, at -14.8% and -17.4% respectively. These 11 names didn’t suddenly show even-worse fundamentals in December; tax loss selling must have played roll in their dramatic underperformance.
- Today, 10 of the 11 names outperformed the S&P 500, with an average gain of 6.8%. With tax loss selling likely near the tail end (or done), this makes sense.
Next: looking at the “macro” of tax loss selling, consider money flows between mutual funds and exchange traded funds over the month. The dynamic here: an advisor sells a money-losing mutual fund, creating a short/long term loss, and uses the proceeds to purchase an ETF to replace it. This has become a common practice in the last decade, even with (or perhaps because of) murky Internal Revenue Service guidance around wash sales. Recent data shows it happened with a vengeance this December:
- The most recent Investment Company Institute data on all mutual fund/ETF flows for US equity products shows a net redemption of $8.4 billion through December 19th. Assuming that investors pulled out another $5 billion (a reasonable estimate given recent volatility) over the last week and the month’s total redemptions would be about -$13.4 billion.
- US equity ETF inflows over the last month total +$24.7 billion. Since that includes a few days from late November, we will assume that December’s inflows will resemble that figure. (Source: www.xtf.com)
- Conclusion: US equity mutual funds (many of them actively managed) have borne the brunt on December’s tax loss sales ($41 billion), only partially replaced by offsetting ETF purchases (that $25 billion from the previous point).
- Important: unless a mutual fund holds enough cash to satisfy redemptions, it must sell underlying equities as net “Sell” orders come in. By contrast, an ETF purchase only creates offsetting demand for stocks if it is large enough to force a “creation” of new shares. That clearly did not happen this month, as the ICI data shows, with ETF “creates” smaller than mutual fund redemptions.
The upshot to all this: tax loss selling made December much sloppier than it otherwise might have been. It depressed many stocks that were already on track for sizeable losses. And it made the lives of active mutual fund managers very difficult as they sold holdings to keep up with redemptions. That filtered through to single stock prices as net inflows into ETFs did not keep pace.
The silver lining in this dark cloud is the “January Effect”, one of finance’s most researched and published anomalies. Two points:
- The January Effect is NOT the idea that US stocks enjoy outsized rallies in that month. Data back to 1928 shows that July (1.6% average gain), December (1.4%), and April (1.3%) are all better bets than January (1.1%). Data here: https://www.yardeni.com/pub/stmktreturns.pdf
- Rather, the idea is that beaten up small cap stocks tend to trade higher in January as tax loss selling abates and more normal buy-sell balances reassert themselves. That 401(k) contributions to US stock mutual funds restart in January for high-income earners also helps, to be sure.
The big questions just now, made more pointed by today’s rally: is tax loss selling done, and have markets re-priced to attractive enough levels to keep the momentum going? Our thoughts:
- The answer to the former is clearly “Yes” – there are only 3 days left in the year, after all.
- But… “Healthy” markets don’t rally 1,086 points on the Dow. Recall that today’s record advance eclipsed the following prior gains: October 13 2008 (936 points, the old record), October 28 2008 (889 points) and March 26 2018 (669 points). In each case, markets chopped around for months after.
- And… Since percentage gains matter more, consider the 2 other instances where the Dow rallied closest to 5% in a day (as with today’s 4.98% advance): March 16 2000 (4.93%) and July 29 2002 (5.4%). The first was near a top; the latter was closer to a bottom, but one that would take almost a year to settle out.
Bottom line: US equity market sentiment hangs on a very fine balance just now. Tax loss selling was a reasonable (if unwelcomed) explanation for December’s parlous performance, paired with trade/Fed/White House headlines to add fuel to the fire. But the calendar turns very shortly. The market’s fortunes need to start turning soon as well, because we’re about to lose one excuse for lousy performance.