Market Update: A Nation Of New Highs - Well, Not Entirely...

by: Invest With An Edge

Currently, more than 90% of the S&P 500 stocks are over their 50-day moving average.

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.

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.

By Jerry Wagner

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 1, 3, 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.

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...

  1. ...the use of the loss is not lost to the investor but is just deferred until the investor has a non-wash-sale trade;
  2. if that occurs within the same year, there is no impact on the investor's taxes at all; and
  3. 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.

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.

I know that any day now I will receive a call from a client, advisor, 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.*

*While Mr. Wagner was a practicing tax attorney, Flexible Plan Investments, Invest with an Edge, and Dynamic Performance Publishing do not provide tax advice. Readers are encouraged to seek the counsel of their own qualified tax accountant or attorney on these matters.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.