Stocks Could Sell-Off Again in 2020 -- and the Reason Isn't Fundamental

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Put simply, a viscous combination of tax loss harvesting and profit-taking in winning names ahead of a potentially higher capital gains tax rate could put overwhelming pressure on U.S. stocks just one more time this year.

This year saw a 34% bear market induced by the coronavirus recession, a second bear market for oil and banks in June and a tech-driven 9% down-move on the S&P 500 in September.

Hang onto the roof, investors.

Tax loss harvesting could be pronounced at year end and the tax headwinds do not stop there. For the winners in this market -- and there have been some big ones -- investors may aggressively take some chips off the table if former Vice President Joe Biden is elected President. He would attempt to raise the capital gains tax for those earning more than $1 million a year from 20% to 37%.

There are some caveats to all of this.

Tax-loss harvesting

Although the S&P 500 has gained more than 5% year-to-date, it has been a bifurcated market, with many stocks down for the year. Tech stocks account for about 30% of the market cap of the index and have risen fiercely, with the Nasdaq 100 up more than 30%. That’s on the back of several tailwinds, the stay-at-home environment among the strongest. But a large portion of stocks on the index are down for the year. Investors may be compelled to sell.

Strategists at Morgan Stanley see 73 U.S. stocks poised for technical pressure because of tax loss harvesting. Among them are Disney  (DIS) - Get Report, down 15% year to date, General Motors  (GM) - Get Report, down 11%, Cigna  (CI) - Get Report, down 13% and Hasbro  (HAS) - Get Report, down 18%.

Tax-loss harvesting is when investors sell a stock at a capital loss in order to offset the capital gains tax in his or her portfolio. Investors do this when the portfolio math shows that selling stocks at a loss, which would carry no tax, will reduce the overall dollar amount in capital gains tax in the portfolio, so much so that selling stocks for losses is more efficient than waiting for those stock prices to regain and then paying capital gains taxes on the total portfolio gain.

Tax-loss harvesting happens most years, but if there are a higher portion of stocks in the U.S. at an annual loss than usual, portfolio managers may do more selling at year-end than usual.

Capital Gains Tax

This adds another layer of potential selling at the end of the year and it would likely come to fruition of Biden wins the election.

In this case, the returns on some of the top U.S. stocks this year would likely be slightly greater selling soon, rather than waiting for incremental gains in the months ahead and paying Biden’s higher capital gains tax. The FAANG stocks -- once again -- have been absolute shiners in the U.S., gaining more than 70% this year.

"While there's always a lot of tax-loss harvesting and capital gains realization in the second half of the year, we expect it will be much more significant this year. And that might then affect the sectors that have had the biggest gains, like technology,” wrote Colin Moore, global chief investment officer for Columbia Threadneedle Investments in a note.

One savior here is that, even in a Blue Wave scenario, the Democrats re unlikely to control Congress by a wide margin, leaving a just few centrist Democrats to potentially keep the magnitude of the tax change at bay. This would reduce the need to sell. 

All in, the potential selling will be weighed against tailwinds like the potentially continued V-shaped economic recovery, which could be accelerated by coronavirus vaccines ready for widespread use. But if these tax issues create a double-whammy for money mangers to sell, an S&P 500 stuck where it is or drifting lower shouldn’t be a huge surprise. 

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