Ten states and the District of Columbia have now legalized marijuana for recreational use for adults over 21. And 33 states have legalized medical marijuana. Joining in, Canada legalized it on a federal level last year, and Mexico’s pot ban was recently declared unconstitutional by its Supreme Court.
With all of the marijuana victories, new highs must be occurring throughout North America. Such is not the case with the U.S. stock market, however. Despite 10 straight weeks of NASDAQ weekly gains, none of the major equity indexes have hit a new all-time high following the fourth-quarter stock market slump to near bear-market levels.
True, earnings growth was down for the fourth quarter, and this week’s growth in GDP failed to hit the lofty 3% mark easily surpassed during earlier quarters of 2018. Small-business confidence has crashed to levels that, while still positive, are back where they were before the 2016 elections. Perhaps these numbers are keeping a lid on the present stock market rally.
Other economic indicators have also been issuing warning signals, and that, too, may be why we have not seen a new market highpoint. Lower consumer expectations and the resulting retail and home-price declines have surfaced. Even jobless claims, which have been in one of their longest downturns … ever, have started to move higher of late. And this type of economic weakness and more have been prevalent around the world.
Yet, technically, each day brings with it another indicator of just how exceptional the run-up in stock prices has been since the low point of Christmas Eve last year. Whether you measure it in consecutive weeks of gains or the percent gained in the shortest time, the latest rally has been one of the best beginnings to a year in stock market history.
You would think that all of the exceptionalism would lead to positive expectations. Yet there seems to be an underlying pessimism among investors today. I think this is rooted in a natural contrarianism that many of us in the industry have learned is justified. More often than not, overenthusiasm by investors has led to disappointment.
Yet we have also often learned that investors tend to be underwhelmed by market strength that comes right after a serious market decline. From a technical market perspective, this does not look like your standard overbought market that could lead to a correction. Yes, statistically we are there. But the move has been so strong and so exceptional that we may have moved from the normal worry at this stage of an overbought market to a market where strength begets strength.
Ten consecutive up weeks in the NASDAQ has always led to higher prices a quarter into the future—and usually a year into the future as well. Currently, more than 90% of the S&P 500 stocks are over their 50-day moving average. Such a strong trend indicator hasn’t happened in over three years. In the past, that long of a drought has led to higher prices over the next one, three, and six months nearly all of the time.
Even in periods when we have registered the lowest GDP growth in the last eight quarters, the pessimism over such a weakening economy has usually been negated by two months of positive price movement. Since the 1950s, this has happened only six other times, but the market ended higher one, three, and 12 months later (median additional gains at one year were 18%).
While I believe a pause is likely over the next few weeks, I also believe it is more likely to be a mere dip and that the market likely has much farther to run. Sure, if the trade talks with China turn negative, a greater decline is possible, but the sheer magnitude of the stock market’s current momentum suggests that a new high is likely.
Our stock market indicators are uniformly positive, causing us to return to a fully invested portfolio. Our Market Regime Indicators are very supportive of a continuation of the rally. In fact, the current stock market stage is the second-best phase of both of these two very different market regimes.
The broader market has already made a new high.
And for the last 50 years, March and April have packed the best one-two monthly punch on a seasonal basis. March has averaged a gain of 1.47%, while April has added 2.25% on average over the last 20 years!
In the past, when positive days have dominated the first two months of a year, the market has soared an average 10.35% over the rest of the year, according to research from Bespoke Investment Group. With a higher percentage of positive days in 2019’s first two months than in the start of any other year in the S&P 500’s over 90-year history (73%), more new highs for that index seem likely this year.
So don’t hold your breath waiting for another downdraft like last quarter’s. Instead, I think you can relax. And, in most of the United States, you could probably even inhale.
Wash sales and active management
It’s that time of year. That’s right—tax preparation season. One of the tax topics that seems to elicit the most questions is the mysterious issue of wash sales. Hopefully, this article will not only dispel the mystery but also answer the questions.
What is a wash sale?
Under the Internal Revenue Code, a wash sale occurs when an investor sells a security and then repurchases a substantially identical security within 30 days of the date of the sale.
What is the effect of a wash sale?
Wash sales defer an investor’s ability to take a loss resulting from a sale of the investment. So if an investor sells an investment on February 1 at a loss of $3 and then buys the same investment back on February 15, the loss from that sale is not recognized (deducted from other income). Recognition of the loss would be delayed until a new sale occurs that is not within 30 days of a purchase (before or after).
Why is a wash sale treated this way?
Before the wash-sale rule entered the Internal Revenue Code, investors could artificially generate a capital loss by simply selling a stock that they had a loss on and buying it back a short time later. This allowed investors to reduce their taxable income by taking advantage of volatility at a time of their choosing, even though they had no intention of not remaining invested in the security. The wash-sale rule sought to eliminate what was deemed a tax-avoidance scheme.
Why a wash sale is not as bad as you might think
First, the wash-sale rule only applies to losses taken outside of a tax-deferred vehicle. It does not apply to trades made within an IRA, 401(k), 403(b), or other qualified plans. It also does not apply to trades within a variable annuity (VA) or variable universal life policy.
Even if the trade is outside one of these deferred income vehicles,
- the use of the loss is not lost to the investor but is just deferred until the investor has a non-wash-sale trade;
- if that occurs within the same year, there is no impact on the investor’s taxes at all; and
- when the loss is deferred, the deferred loss is added to the cost of the investment, so that when there is a sale of the stock in a non-wash-sale trade, any gain is reduced by the amount of the earlier wash-sale loss. Similarly, if there is a loss, it is increased by the amount of the wash-sale loss foregone.
How do wash sales impact active management?
The likelihood of a wash sale depends on how frequently your manager trades. Many strategies trade essentially identical securities on a daily or weekly basis. Such strategies will by definition generate wash sales.
FPI strategies where this is the case are WP Income Builder, Sector Index Rotation, Managed Income Aggressive, Political Seasonality Index (all daily trading), and Fusion (weekly trading). The wash-sales treatment is the trade-off for using more frequent trading to seek downside protection and more frequent profit opportunities.
In addition, tactical strategies, which move into and out of a single index fund or asset class, can have a whipsaw trade in which they buy and then reverse course in a short period. While this rarely happens in many of the tactical strategies (Volatility Adjusted NASDAQ, Self-adjusting Trend Following, Systematic Advantage, Trivantage, and Classic), contrarian or mean-reversion strategies (Contrarian S&P Trading, S&P Tactical Patterns, and TVA Gold) are designed to have short-term trades, and this will occur with some regularity.
Four ways to avoid wash sales at Flexible Plan
- Trade the strategies previously mentioned first in your qualified accounts. None of these trades will be classified as a wash sale.
- Trade these strategies solely in a variable annuity (VA). Jefferson National Monument Advisor is an especially good vehicle for this since they charge only $20 a month—no matter how big or small the account. So it’s $20 on a $1,000 account and also on a $1,000,000 account. It is truly one of the best deals on Wall Street—buying tax deferral for just $20 per month. And almost all of our strategies are available on Jefferson National.
I’ve heard some advisers say that this approach ignores the fact that distributions taken are subject to ordinary income-tax treatment, and they want to avoid such treatment. But with a VA you defer taxation on trades that occur before distribution and avoid dealing with wash sales. If you held the strategies outside of the VA in a taxable account, you would neither defer nor avoid, regardless of when you took money out of the account. Instead, you would have to deal with taxation and wash sales yearly. It’s especially great to be able to avoid both for just $20 per month.
- Use our QFC strategies. All of the frequent trading with our QFC strategies is done within the mutual funds. Trades within a mutual fund are not subject to the wash-sale rule. Reallocations of assets within the QFC strategies generally occur with a one-month-plus trading cycle, so they are not subject to wash-sale treatment. However, Classic and our new Political Seasonality and Systematic Advantage QFC strategies are subject to the whipsaw possibility previously discussed. The other QFC strategies have little chance of a wash sale—and they have a low, low advisory fee—a win-win!
- Restrict your strategies to our less-traded strategies. Our monthly trend-following strategies, such as Evolution Plus, Market Leaders, Lifetime Evolution, All-Weather, any of our Evolution specialty strategies, and our Principled Investing strategies (Faith Focused Investing and For A Better World) trade no more frequently than monthly. In this same vein, A Better Buy & Hold, and Low Volatility/Rising Dividends seek to have no short-term trades.
I know that any day now I will receive a call from a client, adviser, or accountant wanting to know about these wash sales showing up in a client account. Hopefully, with this explanation and a little planning, this will be the last year that happens for our readers.*
All the best,
*While Mr. Wagner was a practicing tax attorney, Flexible Plan does not provide tax advice. Readers are encouraged to seek the counsel of their own qualified tax accountant or attorney on these matters.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding twelve months is available upon written request. Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.