Take advantage of sector rotation and tax policy changes

As you know, materialized capital gains must be claimed, and losses, if any, can be materialized to offset claimable capital gains on your stocks and ETF’s held in taxable accounts. Normally, people use the year-end to dump their losers, and continue to ride their winners.

I think that this year, investors might want to materialize their capital gains in some cases. There is a fairly good chance that the Trudeau government, in an effort to raise tax revenue to pay for its rampant spending, will  need to raise the inclusion rate for the capital gains tax level. The talk that I have heard from accountants is a possibility for that rate to go from 50% to 75% in 2018. That’s a huge jump! This tax rate change is not an absolute of course, but it’s a possibility that we should take into consideration.

I’d like to present some thoughts below on combining a seasonal pattern with some tax considerations regarding our winning and losing stocks.

The seasonals

There is a strategy that makes sense for investors looking to materialize gains or losses on their marketable securities. Markets tend to be strong into the end of a calendar year from this point. The tendency is for the big movers of the year to continue being the leaders until the end of December, while the laggards continue to sell off as investors unload them and materialize the loss.  Come January, stock market participants start to look at the prior laggards in an effort to uncover some oversold/ underappreciated bargains. Thus, there can be a noticeable degree of rotation from leaders to laggards at the beginning of the year.

Note that this does not imply that the current leaders will experience losses in January – it only implies that there may be less upside on those stocks as investors focus more on the laggards during that month. Investment strategies such as the “Dogs of the Dow” strategy were born from this phenomenon. Investors following the Dogs strategy buy the 10 highest yielding stocks in the Dow Jones Industrial Average- which tend to be the prior year’s lower performing stocks of the 30 stocks comprising the index.

The strategy

The strategy is to take gains on anything you suspect has run too high (and may be vulnerable to a period of underperformance) as the year-end approaches. Possibly you are concerned about the runaway NASDAQ index. In this case, if you feel that the NASDAQ market might take a breather in the New Year, you could take some profits on that sector via selling a NASDAQ ETF or a technology ETF – or individual stocks as the year comes to an end. This will materialize your capital gain at current rates of inclusion – unless the Trudeau administration enforces a capital gains tax change prior to year-end.

Remember, you can always buy your ETF or stock back. So if the sold sectors or stocks take a breather or pull back in January, you could easily buy them back at the (hopefully) same or lower price. It may happen that you materialized a gain at a lower tax rate in 2017 – which may indeed offset any risk of losing out on some of the upside, should the ETF continue to rise in the first month of 2018. It’s a game of odds – but odds are somewhat in favor for some rotation of the guard from strong to weak sectors for the first month of the year. Some of the losing  sectors that might be worthy of looking at include retail, energy, consumer staples and precious metals for that January rotation.

Below are 1 year charts of three weak sectors noted above. There are others out there to look at, but only so much room in this blog to post their charts….Watch for a base and breakout pattern on a weak sector as the New Year approaches. The energy base breakout has already started, as noted here.

The tax side

True, you could materialize your losses on underperforming sectors this year and use them to offset any materialized gains. Perhaps you bought precious metals, energy, or consumer discretionary ETF’s when they were higher. These losses could be used to offset your gains on the outperformers that you take profit on this year. However, if you believe as I do, that there is a chance of higher capital gains inclusion rates in 2018 – you could instead choose to claim your losses in 2018.

A realized loss in 2017 might be more beneficial next year if capital gain inclusion rates go up in 2018. Conversely, a capital gain realized in 2018 could possibly be taxed at a substantially higher rate – offsetting any short termed upside gained over that 30 day buy-back period. It’s your after-tax returns that count.

The takeaway

• Seasonal patterns suggest that weak sectors can sometimes pop in the New Year, while strong sectors might take a pause
• There is a potential for the capital gains inclusion tax rate to rise in 2018. This juicy source of new tax revenue for our “Spend liberal amounts of cash” government is a tempting tax grab that is more probable than some might think.
• If you feel you have stocks or sectors that are overbought, you might save some taxes by selling them before year end, claiming the currently lower tax rate, then either rotating into oversold sectors that are breaking out in January.
• If there is an increase in capital gains tax inclusive rate, you would also benefit by deferring a tax loss sale until 2018. True, at this point we can still hold off on claiming a loss for a later year if you do materialize a loss in 2017.