By Michael McKeown, CFA, CPA - Chief Investment Officer
Contrary to what many believe, the economy and stock market are not the same.
Stocks tend to look forward about six months. Most economic data, including Gross Domestic Product (GDP) growth, is a lagging indicator. Over time and across regions, higher growth does not mean higher market returns. The graph below shows that countries with lower growth per person had slightly better stock market returns during the last century.
Performance relative to expectations is what really matters. If you are having a meal at a nice restaurant and it merely turns out good, you might be disappointed. If you are stopping at a fast food restaurant and your sandwich turns out to be excellent, you would be surprised positively.
Studies show over time and across regions that exceeding low expectations for the economy usually comes with positive stock market performance. In turn, disappointing economic results relative to expectations leads to poor stock market performance.
Despite the U.S. economy growing near a 4% rate in 2018, stocks were down on the year through October. Even with the talk of the great economic growth, most asset classes around the globe were down. In fact, by the end of the November, it was the first time since 1972 that no asset class was up at least 5% (that is among eight major asset classes including US Large Cap Equity, US Small Cap Equity, International Equity, Emerging Markets Equity, US Bonds, US Treasuries, Real Estate, & Commodities).
Investors became accustomed to low volatility and positive returns, with only 3 of the last 23 months producing negative results. Year-to-date through December 5th, U.S. growth stocks are the only narrow part of the investment universe up during 2018.
What can investors do in this environment without falling into behavioral traps like market timing?
One solution is to manage taxes lower.
In a down market for many assets, there is a chance to take capital losses for tax purposes. These taxable losses can offset taxable gains, thereby reducing the tax bill to the IRS. For example, if someone sold a stock for a $5,000 gain earlier in the year and had exposure to an international fund, she could book a loss in the international fund. In turn, she would buy a similar fund so as not to bring market timing risk into the equation. If the gain of $5,000 could be offset with a loss (for tax purposes) of $5,000, this could bring something normally taxed at 20% for a $1,000 bill down to $0.
If losses exceed capital gains, up to $3,000 can be used to offset ordinary income. Losses that exceed $3,000 can be carried forward to future years to offset future capital gains or income.
The narrative shifted recently as investors begin to worry about 2019 and 2020. Stocks see slowing global trade, high corporate debt levels, and rising interest rates as a problem. It seems the bar for the economy is going lower. This could eventually set up an environment for where expectations are low enough where investors can enjoy them being exceeded.
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