A Surprisingly Large Year-end Stock Run? Tax Advice Could Cause It

John S Tobey for Forbes writes:  Now is the time investment advisories address tax strategies. This year, an unusual confluence of factors is producing a rare, single-decision strategy that applies to most investors: Hold.

As happened in 1991, this widespread action could diminish supply, leading to a year-end run-up – possibly large. What makes this year special are these five simultaneous drivers:

1. Stock gains occurred primarily in 2013, starting from the November’s worrisome lows, then getting their real kick off in January. This concentration within 2013 means most of the purchases made during this rise are short-term (i.e., less than a year) or are only just becoming long-term. The large tax difference between short- and long-term gains is a strong incentive to wait before recognizing a gain.
2. Gains are spread broadly throughout the entire U.S. stock market. Within the S&P 500 Stock Index, over half the stocks are up more than 30%, and fully one-fifth gained 50% or more. Therefore, many (most) portfolios are filled with large, unrealized gains.
3. Conversely, short-term losses to offset any realized gains are hard to come by. Only 8% of the S&P 500 stocks are down this year, and less than 2% are down 10% or more.
4. Beyond the long-term/short-term status, there is the tax year effect. Sell within the next month and the gains are 2013 taxable. Wait a month and the tax effect is postponed 12 months.
5. Finally, the amount of short-term gains has been affected by investors’ sizeable shift into stocks this year. Swelling this money move is the market’s steady rise that has built confidence and heightened the desire to get in on the gains.

2013 has ingredients for an end-of-year Wow!
In my years of investing experience since 1964, there have been a variety of year-end tax strategies. Most had a muted market effect because stocks rarely move concertedly and in unison for an entire year. The past few years show significant volatility within each, thereby producing no obvious tax strategy applicable to all. However, there have been a few years where conditions aligned. This year is one of those times. For a historical precedent, we can examine 1991.
1991 – A similar time
To understand the importance of 1991 as a comparison, we need to start four years prior.

• In 1987 the stock market produced excellent gains, with growth stocks doing especially well. Then came the sharp October 1987 crash that wiped out most of the earlier gains. Because of the worldwide seriousness of the drop (e.g., the Hong Kong market closed for five days after falling 45%), investor confidence was shaken.
• In 1988 stocks rose (S&P 500 = +12%; Nasdaq = +15%), helping rebuild investor confidence
• In 1989 the S&L crisis was top news and banks were hurt, but the market performed well (S&P 500 = +27%; Nasdaq = +19%)
• In 1990 two hits occurred: the depths of the S&L/banking problems were hit plus the late 1990-early 1991 recession began. As a result stocks fell (S&P = −6%; Nasdaq = −17%). Note also the large difference in two-year (1989-1990) returns between the better performing S&P 500 and the lagging Nasdaq.
• Then, in 1991, with the S&L crisis behind and the general outlook turning positive, good things happened. Investor confidence increased, stocks rose and growth caught fire (S&P 500 = 26+%; Nasdaq = 56+%). The market’s rise fit almost perfectly within the year, kicking off in early January 1991 and peaking in January 1992. This pattern combined with the investor confidence backdrop is why I believe 1991 is a good case study for 2013.

Note: There is one difference that is visible in the graphs below: The Nasdaq’s performance relative to the S&P 500 and the DJIA. In those years, Nasdaq was working to build its reputation and broaden its listings of larger companies that more typically were on the NYSE. Now, Nasdaq has achieved that objective, so the difference in returns is less pronounced. Nevertheless, the Nasdaq, with its large complement of technology and newer firms, tends to have more of a growth characteristic than the other two measures.

The 1991 pattern in graphs
The first graph shows the daily market indexes from the beginning of 1991 to the end of 1992. Note the final burst at the end of the 1991. This is the pattern that I believe could emerge in 2013.

(Stock chart courtesy of StockCharts.com)
The next graph highlights Microsoft, one of the growth darlings in 1991. Up 100+% by mid-December, it added another 50% by mid-January. This example shows the potential power of deferred selling.

(Stock chart courtesy of StockCharts.com)
Now turn to 2013
The first graph shows the near perfect fit of the latest market move into the year.


(Stock chart courtesy of StockCharts.com)

Although the market’s bottom was in mid-November 2012, the real kickoff didn’t happen until the 2012 tax loss selling was over and the market opened up on January 2. Caterpillar’s graph (right) provides an example of that selling period and its effect.

The next graph (below) shows the four top performers this year in the S&P 500: Netflix, Micron Technology, Best Buy and Delta Airlines. These stocks, and the many other high risers this year, are candidates for a year-end bonus run-up like Microsoft’s in 1991.

(Stock chart courtesy of StockCharts.com)
Note: The 2013 tax advice effect is an underlying market push, particularly for the better performing stocks. However, no stock market forecast is without risk. Any stock is susceptible to a fundamental hit, even top performers — e.g., Tesla’s and Best Buy’s recent reversals. Then there is market risk. There is the always the possibility of a large event or mega-fear – e.g., the unlikely but possible escalation of China-U.S. military activity.

The bottom line
The 2013 stock market rise has an unusual combination of factors that could produce an upward push at year-end — perhaps surprisingly large. Widespread gains, produced since late 2012/early 2013 likely mean equally large unrealized gains, many of which aren’t long-term yet. The smart tax tactic is to postpone selling until a holding is long-term or, if already long-term, until the new tax year comes – only one month away.
Even for investors not concerned about the tax effects (e.g., in IRA accounts), waiting through year-end could produce larger gains. On the flip side, 2014 could see some delayed selling occur, as happened in 1992.

One more consideration: Year-end “window dressing” by investment managers
Window dressing is the description of a presumed investment managers’ activity: The buying and selling at quarter-end (especially June and December) in order to have published holding reports that include “winners” and exclude “losers.” Although, in my 30 years of working with managers, I never witnessed this activity, it has been a traditional Wall Street assumption. Therefore, the belief in it, alone, could help cause the effect, thereby producing an added boost to already well-performing stocks.