10/19

Getting Down To Brass Tax

It's That Time Of The Year...That's right, tax loss selling season.  And this year is already shaping up as something special as losses just seem to arise out of nowhere just about every day.  So many to choose from, so little time.

The mutual fund crowd closes it's tax books at October month end.  Individuals have until the end of the year to cheat the government out of its fair share of capital gains tax revenues.  The issue of not only individual security tax loss selling, but more importantly the tax issues involved in mutual funds are taking front and center stage.  This year there are some very important twists that may affect market action more than one would expect.

For starters, and since we are being a bit lazy, the following is a reprint of something we published about one and one half years ago.  (A few sentences have been inserted and some changed to update the "action" a bit.)  It's a darn good bet that the concepts presented are finally coming home to roost.  For  readers who have seen this before, we apologize.  For those who haven't, take a quick peek and then well get to some concrete number examples and discuss the potential market effects looking out over the next few months. 

Unrealized Capital Gains:  The Dirty Little Secret Of The Mutual Fund Industry

    Up until now, we have been the beneficiaries of the greatest bull market of all time.  During this decade alone, the public has written the mutual fund industry a depository check for over $1.2 trillion dollars.   What a great deal as investors have enjoyed increased paper wealth.  Most believe this will continue as far as the eye can see.  The trust in paper generation of wealth is truly extraordinary.  For those still wondering just how this market has risen to such a "thin air" atmosphere, we happen to have over a trillion reasons why.

    With the torrent of cash flowing into mutual funds, those who have chosen to redeem over the past three to four years have been easily accommodated with immediate payment.  No need for funds to do a lot of selling to meet redemption's.  Net inflows have swamped the demand from those who have chosen to leave the party early.  With the top S&P cowboys whooping it up the loudest over the past three years, there has been absolutely no sense of urgency on the part of fund managers to sell the Microsoft's, the Cisco's, the GE's, etc.  In fact, they eagerly continued to buy as these balloons lofted ever skyward.

    As you know, mutual funds pass out both dividend income and capital gains each year.  No need to really worry about the dividends as we are currently clocking in at one of the lowest yield levels ever recorded in US financial history (and have been for some time).  For taxable investors it's a minor inconvenience of the moment.  Capital gains realizations, however, can be driven by many variables.  (Thank God for the current crop of talented fund managers, as a sense of history and valuation are clearly not among their "variables" for selling.)  The spectacular performance of the markets, especially over the last three years, has not been matched by capital gains distributions of the mutual fund industry.  Clearly there are unrealized gains embedded in these funds awaiting ultimate distribution.  Even beyond the last three years, this has been the greatest long term bull market of all time whose origins date back to the early 1980's.  Mutual fund managers have historically been relatively sensitive to the realization of annual gains.  For taxable investors, it's an immediate rebate to Uncle Sam.  What's so bad about unrealized gains?  At this point, even with a rotten market this year, a large number of investors in America still have some type of unrealized gains in funds or individual securities.

    We believe the problem will initially be felt by new taxable investors who have purchased stock oriented mutual funds in the eighteen months or so.  Imagine a scenario where we go into a protracted (2-3 yr.) bear market and the public decides to sell 20% of their stock fund holdings.  Just 20%.  (We know this is a stretch for some, but believe us, it is well within the realm of human possibility.)   Newcomers to stock funds will not only lose value in a bear market, but will also be distributed capital gains they were never there to enjoy in the first place.   Imagine losing money and making a very big tax payment for the privilege.  In this scenario, it isn't just new investors that face losing value and paying taxes.  If the markets don't shape up, and soon, this will be a common theme among the majority of fund holders this year.  If we get to the point where the public demands fund redemption's, the greater this embedded gain  tax problem will become.   It's axiomatic that former winners are sold to meet redemptions because the former winners are the last to lose liquidity.  In today's 800 number mutual fund nirvana, redemption means now (1-800-GETMEOUT).  Not when it's convenient.  Not in the next rally.  Now.  In a bear market, liquidity will be sold (hard).  We are already seeing this. This is clearly not the kind of experience that reinforces the "I'm a long term investor" swagger.  This scenario is not so hard to imagine at all.  It may be right around the corner.

    If you think stock oriented mutual funds are a problem, think about the index funds.  Fully invested by nature at all times.   No cash.  Ever.  The recipients of mountains of cash during the 1990's.   The embedded gains have to be staggering.  (You will get a sense for just how staggering in the table below.)  Index funds will be a taxable investor nightmare in a bear market accompanied and abetted by public selling.   It's no fun losing money.  It's no fun paying taxes.  Pour in equal amounts.  Shake vigorously, and you have the perfect LTHS cocktail (Long term horizon shortener).  Redemption of index funds may become a particular problem.  We didn't mean to spoil Happy Hour.  Anyone for another drink?

    Up until now we have quietly suggested the public would redeem and set off the tax fireworks.  The ultimate irony may turn out to be that the mutual fund managers themselves spark the selling by trying to maintain performance in a bear market.  (As you know, this is accomplished by losing the least amount of money relative to your peers.)  Either way, we believe this unrealized gain/tax problem will be a major concern in the next bear market as a potential driver of fund liquidation's.  At least when you own individual securities you do not have to sell and trigger any gains.  It's a huge difference from the mutual fund complex as your neighbor can become your biggest problem.  If your neighbor sells, he/she may generate a tax problem for you.

    So you're not a taxable investor.   You're safely tucked away in a 401(k) and you are definitely in it for the long term (at least for now).  Taxes are not a problem.  Could the taxable seller drive the market at the margin?  Could be.  That's our concern for what may end up being the perceptual effect on the non-taxable investor.  This issue is really an anecdotal negative for the "future files".  It will not be the cause of a bear market.  But, in bear markets, it's often movements at the increment that surprise you.  If you own mutual funds, go back and look at investment percentage gains versus percentage capital gains distributions for your funds.  Be aware of the potential powder keg of unrealized gains potential.  We posit the humble suggestion that perhaps it would be wiser to sell a fund entirely and pay the capital gains on the entirety rather than being bludgeoned by capital gains distributions during a bear market and losing value at the same time (and still not have paid your entire personal capital gain of market over cost).  Is it time to bail out of your favorite taxable stock/index funds?   Using Alan Greenspan's words of comfort, relax, "we'll only know it was a bubble if it bursts".  Thank God.  Now we feel a lot better.  Alan, has it burst yet?

Not All Funds Are Created Equal...Let's have a look at some numbers so you can get a sense of what investors potentially face.  The source for the numbers is none other than Morningstar.  First, the big kahnua non-index fund (sort of), Fidelity Magellan:

First a few observations in this and the tables to come.  NAV's (Net Asset Values) are net of annual gains and dividend distributions, so we are certainly not double counting here.  In this and the following tables, pay particular attention to the years 1996 and beyond.  As you know, a ton of money poured into the funds in the past few years.  Likewise, the market obliged by going higher (on the back of that money)...until now.

Magellan has actually done a decent job of passing out gains over time.  This clearly shows that there was active management of the portfolio.  Although we do not have the numbers for 2000, we understand that manager Bob Stansky and friends blew out of a fair chunk of their tech holdings some months back.  Assuredly capital gains distributions are on their way unless some pretty big tax loss selling has/will have taken place.

Probably the biggest single holder of unrealized gains we can think of is the following:    

The table basically says it all.  Capital gains passed out of the Vanguard 500 fund over the last ten years are negligible at best.  Even lowly dividend income has surpassed gains realizations by over four to one.  If ever Vanguard faces relatively significant redemptions, capital gains realizations will be a given.  By nature, the bull market has created an incredible amount of unrealized gains in this and most all index funds.

Lastly, as a final example the following table is Chip Morris' T. Rowe Science and Technology Fund:

Relatively few gains realizations until last year.  Pre gains distributions, this fund was up close to 100% last year.  Morris may be the anomaly in that his experience taught him to take some chips off the table (no pun intended).

What's Ahead?...If mutual fund managers were looking to offset capital gains realized earlier in the year, they have had plenty of opportunity to do so over the last month and one half.  Clearly the action in the major indices and stocks has been more than tax loss selling effects.  The typical pattern each year is that the weak stocks get weaker as you move through September and into October as the funds square up pro forma capital distributions positions.  This year it was many of the former strong that blew up along with the weak getting weaker.

At the moment, what is unknowable is how much selling was done for momentum or portfolio management reasons and how much for tax loss reasons.  In fact we have had two major events this year for much of the beloved and over owned tech universe.  The April/May Nasdaq hit and the September/October Nasdaq hit.  Regardless of tax loss planning, many a portfolio manager may have been unloading the favorites (MSFT, INTC, CSCO, DELL, etc.) just to conserve sheer performance.  We have to believe that this type of action created a lot of gains, possibly unintended gains, as these were the very stocks that delivered the bulk of investment performance over the last few years.  To offset those unintended gains taken for investment performance reasons, there may have been extraordinary pressure on other liquid sectors of the market in September and October just for tax neutralization reasons.  If so, a broad based bounce post the bulk of tax loss squaring is not an unreasonable assumption.  Be prepared for a move based at least partly on lack of pressure, not necessarily massive buying.

The Role Of The Mutual Fund Investor...It's been somewhat axiomatic that investors refrain from putting gobs of money into mutual funds near year end strictly to avoid capital gains distributions in mid to late December.  In the greed driven market of the past few years, this has meant nothing as money has plowed in regardless of distributions.  In fact the monetarily driven NASDAQ blast off in October of 1999 sucked in money straight through distribution season.  This year may be a bit different.

Could it be that investors sell their funds prior to distribution time strictly to avoid potential gains distributions in what has been a down year?  It could be.  After all, this could be the first year in many a moon where investors have down performance and they are forced to pay taxes on distributed gains.  A little slap in the face.  Possibly a stark education also.  It really depends on individual situations, embedded long term gains in their specific funds, etc.  If a certain amount of mutual fund holders sell to avoid gains distributions nearer year end, that could indeed create more selling pressure in the months ahead (possibly counteracting the lifting of selling pressure from the fund complex).

You know and we know that at some point, investors are going to want their money back.  A significant drop from here (20%+) would probably get the ball rolling as recent declines have actually caused mom and pop investors to "start asking questions".  We believe the embedded capital gain issue  may begin to receive much more attention in the months ahead.  Be prepared.

Just Another Day...Ho hum.  Two near record percentage moves in the NAZ in the past five trading days.  Yawn.  Getting a little boring, isn't it?  What can be done to really spice things up around here anyway?  You know tomorrow (Friday) is options expiration.  Let us pose a simple question.  Suppose for a minute you are a hedge fund long momentum tech stocks at the end of August.  You had a pretty nasty slap.  Did you just sit there through September and early October and just take what was coming to you?  Of course you didn't.  Chances are you shorted the NDX futures or put on some other creative hedge.  When the NDX futures bolt out of the starting gate like last Friday and today, you quietly and humbly GET THE HELL OUT.  No questions asked.  Could it be that something like this may have had a bit to do with today's little romp?  Funny GE was down on a day when the S&P was up over 3%.  It's just a good thing that all the top NDX dogs and S&P top tech were spiking to make up for it. 

We've shown you the following chart before and now here's an update.  Classic Edwards and Magee topping formation "diamond pattern".  Behold the "Dow Diamond dogs":

It Ain't Over Till It's Over...Anything can happen in the wacky market environment of the present.  Now that the earnings are out of the way, maybe the party will continue.  Folks now have the chance to buy many of their favorite techs at what is perceived as sale prices.  The only hang up is that the techs will go into the 4Q confessional box in about 8-10 more weeks.  Oh well, that's basically a lifetime in the new era. 

We present the following S&P chart for long term perspective.  Patience is a virtue, even in a bear market.  We previously advised against betting on near term crashes.  The NASDAQ chart looks sick.  The DOW simply is not far behind.  The S&P alternatively, is still bouncing off a longer term trend line.