March 2003
The Third Year
| "This is the third time; I hope good luck lies in odd numbers.... There is divinity in odd numbers, either in nativity, chance, or death." |
| --William Shakespeare The Merry Wives of Windsor |
OU'VE PROBABLY HEARD THE ARGUMENT that history favors the 2003 equity market. This one's making the rounds among pundits seeking to use history as a guidepost for the coming year.
Essentially it holds that over the past century, the S&P 500 has only suffered one four-year period of declines. The past three years have been down, so the odds heavily favor positive returns in 2003.
It would be great if you could count on this, but unfortunately share prices are the result of supply and demand, economic, and political conditions. These factors are constantly changing and never the same. There may be similarities to previous situations, but there aren't any direct correlations.
More importantly, the market doesn't owe anyone a good year. It always yields the results commensurate with supply and demand, economic, and political conditions.
But don't misunderstand, the fact that we can't be assured of a positive year doesn't mean there isn't something very valuable to be learned from studying the past. It just might not be what you'd expect.
Down Times
The S&P 500 has suffered comparatively few down periods. Most are concentrated around the Great Depression (1920-1932) and World War II (1939-1941). Given their rarity, we decided to look at index returns in the year following two rather than three consecutive down years. If nothing else, this provided additional data points.|
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 Source: Ibbotson Associates Over the 77 years from 1926 through 2002, there have only been seven times when the S&P 500 has been down two consecutive years or more. |
The goal was to see if there was a definitive pattern in returns in the third year following two consecutive negative ones. This is relevant now since 2001 and 2002 were down, making 2003 a "third year". The nearby table summarizes the findings.
The seven years shown on the table were "third years" -- they followed two consecutive annual losses on the S&P 500. Perhaps most remarkable is the fact that since 1926, there have only been seven.
The columns in the table show the third year returns of the S&P 500, intermediate term U.S. Treasuries, the 30-day T-bill, and a balanced portfolio of 50% S&P 500, 45% intermediate term U.S. Treasuries, and 5% U.S. T-bills. The latter represents a fairly common mix of stocks, bonds, and cash.
The best performing asset class is highlighted in each year. The rows at the bottom of the table show each classes' highest, lowest, and average third year return.
Surprise Winner
As noted above, the third year is certainly not the charm for stocks. After suffering two consecutive down years, stocks only outperformed in three of the seven instances. In those years when they didn't, there were still some substantial double-digit losses (1931, 1941, 2002). So much for being "owed" a good year.Bonds seem to be a safer third year alternative, suffering a loss only in 1931. Even so, their weak returns in three of the remaining six years (1933, 1941, and 1941) are less than their coupon, signifying a capital loss.
The 30-day T-bill was the best performing class in 1931, yet as you would expect, its average return over the seven periods was the lowest of the four alternatives. As a cash investment, returns were never negative.
The balanced portfolio was the only class that failed to outperform in any one period. That stands to reason inasmuch as it is composed of the other classes. There's no way that in any given year that it could do better than its best performing components. One hundred percent of the best performing class will always have a higher return than a mix with lesser performers.
Nevertheless, on average the balanced portfolio was the best performer. Are you surprised?
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You shouldn't be if you understand the principles of asset allocation. This outgrowth of Modern Portfolio Theory holds that by systematically combining risky assets, portfolio return can be enhanced and risk controlled. That's what the balanced portfolio is doing here relative to the other three asset classes.
In every instance a portion of it is invested in the best performer -- regardless of which class is the best. By the same token, it also holds some of the worst performer, but not 100%. In any given third year, the balanced portfolio return falls somewhere between that of the best and worst performing asset class.
If you knew stocks -- or any specific class -- would outperform, you'd obviously want to own only that class. But as these historical figures demonstrate, you never know what the best performer will be. The fact that the previous two years have been down provides no particular insight into the third year.
In a turbulent market, there's no assurance that any asset class will do better than the others. The most prudent approach is to spread the risk across all alternatives.
There's nothing magical about the balanced mix (50% stocks, 45% bonds, 5% cash) that we've used here. Risk averse investors might want to consider allocations that favor bonds or cash while the more aggressive may prefer a higher percentage in equities.
The specific mix really doesn't matter. The lesson of this study is that a balance -- whatever you choose -- between stocks, bonds, and cash is the most reasonable approach in a volatile market.
In 2002 it didn't matter what kind of stock fund you had, large cap, small cap, growth, value, foreign, or domestic, you probably lost money. The chart below shows the average one-year loss for various categories.
Now what do you do? If you sold out last year is it time to get back in? If you're still holding on, do you stay where you are or look for greener pastures?
(One important caveat: If your fund has a load -- either front or back end -- you need to consider the impact of this cost. If you just purchased your fund in the past few months, selling now may not be the right option for you.)
Unless you've held the fund for quite some time, 2002 probably left you with a loss. If you continue to hold on, that loss is nothing more than a reminder of a bad year -- and possibly a bad investment decision.
Now you may have an aversion to selling, after all, isn't the stock market about to make a comeback? If you hold on, don't you have the opportunity to recoup your loss?
Sure you do, but you don't have to do it with that particular fund. Truth be told, mutual funds -- especially domestic equity funds -- have become something of a commodity. If, for example, you're in a large cap growth fund, there's probably 50-100 funds with similar investment style and fees.
By selling now and swapping into one of those, you realize your loss for tax purposes but really maintain the same position in the market. If you're truly enamored with your specific fund (didn't it lose money last year?) you can still sell and buy it back after 30 days. If you repurchase any sooner, you run afoul of the "wash sale" rule and don't get the benefit of the loss.
The downside to this approach is that you're out of the market for the 30 days while you wait. Maybe that isn't so bad, given how stocks have behaved so far this year, but you do run the risk of missing a rally while you wait.
Regardless of what you decide to do afterwards, selling now will turn the paper loss into a realized loss, providing a tax deduction for your 2003 return. If you held the fund for more than a year, your loss will be considered long-term and can be used to offset any gains you take this year (you do hope to have some gains, don't you?). Any loss left over after this netting can then be applied against up to $3,000 of regular income. If there's still some loss left over, you can carry it forward to use in the following tax years.
The decision here isn't as clear as the decision to sell. If you're a long-term investor and not a market timer, you should be in the market at all times. On the other hand, if you're already in cash, aggressively buying before the end of the bear market will create new losses, not new gains.
Complicating matters is the fact that most of the market's gains are achieved in only a few trading days. Many of these occur right at the beginning of a sustained rally. If you wait until the rally's for real, you may have already missed most of its gains.
So what to do?
If you're an asset allocator, having divided your portfolio between stocks and bond investments, you might consider diving right back in. Asset allocation models are designed to work over the long-term and are usually only harmed by attempts at market timing. Yes, stocks may have further declines, but you have the fixed income portion of your portfolio to offset this -- that's the purpose of asset allocation.
If you're all in cash or only have equity investments, you might want to take a more conservative approach. One of the benefits of using mutual funds is the opportunity they afford to dollar cost average in. With such a volatile market, this is a good time to take advantage of this benefit.
To dollar cost average, first decide the amount you want to invest on a regular basis, whether it be weekly, monthly, or quarterly. Once When stocks (and your funds' share price) are up, you'll be buying fewer shares and thereby reducing the risk that you're over-investing at the top. When stocks (and your funds' share price) are down, you'll be buying more shares near their lows and increasing your opportunity for gains.
That's right, the fund's capital losses. They can ultimately help reduce your tax bill in the coming years while at the same time increase your net return from the fund.
Here's why: The current tax code requires mutual funds to distribute their taxable gains to their shareholders by the end of the fund's fiscal year. Unless it's sold for the exact purchase price (highly unlikely), there's a taxable gain or loss every time the fund's manager sells one of its holdings. If the transaction results in a gain, this amount must be distributed to the funds' shareholders of record at the end of the fund's fiscal year, even if they weren't shareholders when the transaction occurred.
This is why in the 1990s many fund investors were rudely surprised when they received taxable capital gains distributions from go-go funds
But after the past three years of equity losses, Morningstar reports that the average domestic stock fund's capital gain exposure is -51%. In other words, the average fund has losses equal to 51% of its total assets.
Although gains must be distributed to shareholders each year, losses are retained within the fund. As the manager trades stocks and realizes gains, these losses can be used to offset them. The fund can carry them forward for as many as eight years to use them up.
And that's why you should consider a fund's capital gain (loss) exposure. If you select funds that have relatively high loss exposures, you can delay or even eliminate future taxable capital gains distributions. The right decisions now can save you from taxes in the future.
You can get an idea of a fund's potential loss exposure by looking it up at the Morningstar Website or contacting the fund directly. Obviously this shouldn't be the only factor in choosing an equity fund, but it's certainly worth considering. All else being equal, a fund with a greater loss could quite possibly be more tax efficient in the long run.
That assumes, of course, that the fund's losses are more a function of the market than the manager's incompetence. That's another factor worth considering.
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is Your Gain
"We all have strength enough to endure the misfortunes of others.
" -- Francois de La Rochefoucauld
F MISERY LOVES COMPANY, EQUITY FUND investors should be having a real love fest. They have plenty of company.
Your Loss
First off, if you haven't already sold, go ahead and sell. Why? Well it's a case of making lemonade out of lemons.
Category
2002
Return*
All Domestic Funds
(-22.7%)
All Large Cap Funds
(-23.4%)
Large Cap Growth Funds
(-26.9%)
Large Cap Blend Funds
(-23.1%)
Large Cap Value Funds
(-19.3%)
All Mid Cap Funds
(-21.4%)
Mid Cap Growth Funds
(-26.2%)
Mid Cap Blend Funds
(-21.2%)
Mid Cap Value Funds
(-14.5%)
All Small Cap Funds
(-22.4%)
Small Cap Growth Funds
(-29.2%)
Small Cap Blend Funds
(-19.9%)
Small Cap Value Funds
(-12.7%)
*Equal Weighted
Source: Standard & Poor's
The Decision
Once you've sold your current fund, what do you do? What if you sold last year, do you get back in now?
you've done this, select the fund or funds to purchase and begin your regular investment. These should continue at your chosen amount and interval regardless of market conditions.
Their Loss
In selecting the new funds to buy, you'll probably want to look at style, track records, managers' tenure, expenses, etc. But there's one other thing you should consider: the fund's capital losses.
As stocks were going up and fund managers were actively trading them, capital gains built up in the funds. These gains had to be distributed by the end of the year. The shareholders who received them were the ones left holding the tax bag.
The right decisions now can save you from taxes in the future.
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