December has historically been a very favorable month for the US equity markets. Whether this is due to the big institutional money managers being strongly incentivized to help the market end the year on a positive note, or just from the psychological boost that comes from the holidays, we may never truly know. What we do know is that the last couple of weeks of the year can bring some additional selling pressure on stocks that have had sharp declines during the year. Very simply, this is caused by tax-loss selling, a process where investors that are subject to U.S. tax laws will “harvest” (i.e. sell) positions that have a loss in order to reap a tax benefit. For those holding positions prone to tax loss selling, it can be like rubbing salt in your wounds as your positions that have not fared well this year get dumped right around Christmas time.
This year we may experience an exaggerated version of this effect for several reasons. The main one is that investors are expecting tax reform to be signed, sealed and delivered for 2018. All else being equal, investors would rather sell a losing position now in December where it gives them the most benefit rather than selling a few months later for a lesser reward. The most obvious impact from tax reform is the reduction of the rate for the highest tax bracket. This incentivizes investors to harvest their losses in 2017 while the highest marginal tax rate is still 39.6%. Short term capital gains (those of less than 1 year) in the US are taxed at your personal rate and not the 20% used for long tern gains. The Senate version of tax reform will give the wealthy a bit of a bonus by shaving that maximum personal rate to 38.5%.
Furthermore, one of the features of the proposed tax reform is the elimination of an investor’s ability to select which lot to sell. Currently, if an investor has purchased a stock at several different points in time (creating multiple “lots”), and he wants to then sell a portion of his position he can select which lot is most advantageous from a tax perspective. This usually means selling the lot with the largest loss. The proposed tax reform includes a provision that would disallow that practice and force investors to sell the oldest lot first in a FIFO manner (First In First Out) regardless of the gain or loss which amounts to a backdoor capital gains tax increase. Although we do not yet know if this will make it to the final version of tax reform, investors are very likely to be taking action and selling affected positions before 2018.
With the S&P 500 up 18% this year, most investors are sitting on some hefty gains and to the extent that profits are being taken, the pressure to offset the tax impact increases. However, the selling may not be limited to this year’s losers either. The tech sector has had a massive gain this year and could cause some institutional funds to do a bit of portfolio rebalancing before yearend. This may even lead to a bit of a vicious cycle as investors trying to align their portfolios to benefit from tax reform (specifically the lowering of the corporate tax rate), which would entail selling off stocks within sectors that have low tax rates such as technology and rotating to sectors that typically pay high tax rates (financials, consumer and telecom). The more technology stocks with large gains that are sold, the more demand there will be to harvest some of those losers.
Many of the big losers that can see additional selling are clustered within the consumer discretionary and the energy sectors. Within consumer discretionary, the traditional brick and mortar department stores have been one of the worst groups in the market as their businesses struggle against the move towards ecommerce. Even with the recent rally these stocks have had in November, many of them remain far below their 2016 levels. For example, JC Penney is down 61%, Sears Holding is down 54% and Signet Jewelers is down 43%. Even bellwether retailer, Macy’s, is down 27% this year. Outside of direct brick and mortar retail, athletic apparel distributor Under Armour is down 53%. In the energy sector, quite a few service companies were bid up after President Trump’s election in the last 2 months of 2016. However, 2017 has been a different story as US Silica is down 41% and Hi-Crush Partners has been well crushed for 46%. Retail and energy are not only groups where potential tax loss selling candidates can be found, as generic drug maker Teva Pharmaceuticals is down 55%.
Column by Charles Castillo, senior portfolio manager at Beta Capital Wealth Management. Crèdit Andorrà Financial Group Research.
For Alicia Miguel
For Fórmate a Fondo
For Funds Society, Madrid