Tax Loss Season is Open

Year end 2017 could be particularly volatile for many names.

The day after Thanksgiving is referred to as Black Friday. This is because, up until then, many retailers have operated at a loss all year. Then, the start of the holiday rush puts them “in the black” as they make all their profits over the rest of the year. The holiday period in retail is their big money driver, the time of year where customers spend money in a less price-sensitive manner…parents NEED to get their shopping done before Christmas.

Stock market traders have seen a similar effect over the years. Don’t get me wrong, I’m well aware that traders do tend to be profitable all year. But, the last month of the year can be a time of great opportunity for investors to make outsized gains in a very short time period due to trading patterns that tend to occur like clockwork around each year-end.

The year-end effect that creates the most volatility, and therefore opportunity, for traders is tax-loss selling. This effect occurs when investors begin to realize how big their capital gains tax bills are going to be and start selling losers to offset the tax burden. Similar to a husband desperate to buy anything for his wife on the last shopping day before Christmas, tax-loss sellers can become desperate to hit any bid as the last trading days approach.

This selling can become indiscriminate of price as the combination of wanting to lower taxes along with just being frustrated that you ever bought “that damn stock” leads to almost irrational selling. This happens every year, but is exacerbated in years where the market has moved dramatically higher, giving everyone gains in their portfolio. It can also be further exacerbated when there is going to be a change to tax laws that impact capital gains.

This year is shaping up to be a year of both large gains for investors with a substantial change in investment income taxes coming in the following year. The result will likely be some extraordinary opportunities in the market for those willing to drink from the firehose of selling that is certain to crush some stocks over the next few weeks.

There will be investors with extraordinary gains this year…

The strength in the stock market over the last few years has been legendary. By some counts, we are in the second longest bull market in history, with the current rally having started in 2009 and no pullbacks of 20% or more in the S&P 500 during that time.

But, the gains in the market have really been centered around a smaller group of large cap stocks, particularly in technology and biotech. These sectors are very heavily scoured by retail investors, so there are many people with large gains as a result.

Meanwhile, the bifurcation in the market has seen small cap underperform, especially the micro cap sector. Proof of this is that the Russell 2000 has had two bear markets during the long S&P bull market. The most recent bear market for the Russell 2000 was in mid 2015 to early 2016 when the index suffered a 27% decline.

I wrote about the causes of this tale of two markets, large versus small, last December when I said that index investing was causing large cap stocks to outperform. There has been a ton of money going into index funds for years, with this year the peak in my mind.

The bottom line, 2017 is a year of extraordinary gains in many stock, and, yet, a number of losers, particularly in the micro-cap sector.

Meanwhile, there’s an incentive to lower your tax bill for 2017…

Trump is calling his tax plan the “Largest Tax Cut in History”. The proposed plans are indeed suggesting large tax cuts, along with a myriad of changes to deductions and other fees, etc., all of which would create a large reduction in taxes for the American people. It also is highly unlikely to be passed in anything resembling its current form.

Here below are the proposed changes, on a broad scale.

On the surface, this seems rather benign from an investment impact as the proposed capital gains tax of 20% is unchanged from current laws. However, there is a change below the superficial tax rate that will indeed impact investors; Trump is proposing eliminating the Net Investment Income Tax.

The Net Investment Income Tax is what funds ObamaCare. It is a tax of 3.8% on all investment income for those earnings above $200,000. This is, of course, the income group which includes most stock market investors.

Putting this tax change in perspective, in terms of how it will affect investors, imagine if you had $500,000 in capital gains booked in 2017. You will be paying, on top of regular capital gains of $100,000, an additional $19,000 in ObamaCare tax.

However, if you were to take losses offsetting these gains, your tax savings would be larger this year than next. Thus, if you had a losing stock position, even if you like the position, there’s an incentive to take a loss in it and repurchase it after 30 days.

If you can take $500,000 in losses, your tax bill goes to zero. Even if the trade costs you close to $19,000 in expense, in terms of commissions and paying more to repurchase than what you sold for, it’s a worthwhile trade.

The bottom line here is that, there are many people with large capital gains. And, for those about to face a big tax hit as a result, there’s an additional incentive to take losses to offset those gains here in 2017.

How best to play this?

The strategy here is actually as simple as one might think. Look at the worst performing stocks as candidates for purchase. Typically this group of stocks has the weakest fundamentals, hence the underperformance. However, that’s not always the case.

I look for companies that I find interesting fundamentally, but whose shares are sitting below the level of their most recent financing. These are the companies that seem ripe for tax-loss selling.

Shares of companies like Catasys, which is down recently on investor’s concerns about business slipping a quarter. In my mind the fundamental thesis is intact, yet the shares have taken an inordinate beating. This is likely being exacerbated by tax-loss selling. I’m taking advantage of this situation by buying shares on the weakness.

At the same time, stocks that are up big are likely to remain lofty through year end. Just as there’s an incentive to take losses this year, there is a larger than normal incentive to postpone capital gains for another year, to avoid the ObamaCare penalty.

As such, stocks that have been strong will likely remain strong into year-end even if their valuation is extended. Take profits in these stocks now, with the expectation that you can repurchase them cheaper next year…or, if you have a tax problem in them as well, short against the box, which is a method of establishing a simultaneous short position to hedge your long. This avoids creating a capital gain, but protects you against a downturn in the shares.

Regardless of your strategy, realize this. The coming two months into year-end will be one of extraordinary opportunity in the market. There will be lots of volatility in many names, more so than is normal into year-end. Be prepared to be surprised by movements in stocks and take advantage of them. Expect your winners to run and your losers to get more painful; and fade these moves if they are simply tax related as they will likely reverse after the first of the year.

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