The following is from a Special Report sent to subscribers of the Forbes Special Situation Survey.
In our Oct. 7 Special Report we discussed the unprecedented level of volatility plaguing the markets. Things have gotten much worse since. Both the intra-day and inter-day swings on the Dow and other major indexes are simply mind boggling. There have been a number of days when the Dow opened up or down several hundred points only to finish in the opposite direction.
We believe this volatility will continue through the end of the year. We believe much of it is due to tax-related trading. Earlier this year, many investors sold stocks for hefty capital gains. They then invested that money back into the market. Now they are sitting on large capital losses. These investors will sell shares in order to realize those losses to offset their earlier gains in order to minimize their tax bill. This activity puts downward pressure on stocks.
Other investors have already realized large capital losses. Because the IRS limits investors to only $3,000 per year in net capital losses, these investors have an incentive to sell into rallies in order to realize whatever gains they can to offset their large losses. This activity keeps the market from going higher than it otherwise would.
Of course, on top of all this, hedge funds and mutual funds are selling in order to meet redemptions. Investors who want their money back from hedge funds by yearend must notify them by Nov. 15. If large numbers of investors do so, selling pressure could increase between now and the end of the year. Mutual funds are also selling heavily. Many investors who have seen the value of their mutual fund holdings collapse will be doubly shocked when they realize they will owe capital gains taxes on shares the mutual fund managers sold at a profit.
Given the extreme sell-off in stocks this year, subscribers should keep a watchful eye on their tax situation. Make sure you realize net losses of $3,000 ($1,500 if married and filing separately). If you realize more than that, you will have to carry forward the losses into the next tax year. That’s not a bad thing, but it is not as valuable as taking them now.
Once all this tax-loss selling is completed, the market will stabilize. We expect volatility to subside once January rolls around. Furthermore, even though the economy will exhibit tremendous weakness for at least another six months or so, the stock market is likely to rally long before the economy improves. A strong rally after a bad year is not unusual. A 50% rally in the Dow from current levels would bring us back to only about 12,750. A 25% rally translates into a 10,625 Dow. This is a level that looks quite achievable by the end of 2009.
