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Written by: Kevin Ervin
The past month has contained some of the highest levels of stock market volatility of the past few years. While this can be somewhat unnerving, this is not an entirely bad situation for investors. Please read below to learn about some of the hidden benefits of recent stock market declines.
RISING INTEREST RATES
The primary cause most often cited as the reason for the decline in the stock market earlier in February was rising interest rates. There have been times in history where rising interest rates have caused some significant subsequent negative returns for the stock markets. Investors have not forgotten about these periods. However, when one looks more closely at the association between rising interest rates and subsequent stock market returns, the periods of negative stock market returns resulted when the 10-year US Treasury yield was above 4% at the beginning of the measurement period.
From the below graph, you can see that since 1963 that stock market returns have been positive over subsequent 2-year periods when 10-year Treasury yields are rising, when interest rates are rising from a low starting point. This fact pattern is generally indicative of a growing economy, rather than runaway inflation concerns, which would tend to be the case if interest rates were rising from an already elevated level.
While it is true that rising interest rates do cause the prices of bonds that one already owns to decline, this impact is relatively small for bonds with short remaining maturities or floating interest rates. For example, a 1.00% rise in the interest rate for a 10-year US Treasury bond would cause a price decline of almost 8.5%. However, a 2-year US Treasury note would suffer a price decline of less than 2% if interest rates were to rise on this maturity by 1.00%. The main reason for the different price reactions is that the holder of the shorter remaining maturity bond will be able to reinvest the maturing proceeds at a higher interest rate in a relatively short period of time, as opposed to the holder of a longer maturity bond, who will be stuck with its low yield for several years.
For some time, we have maintained relatively short average maturities in our clients’ bond portfolios, so the losses due to rising interest rates have been minimized, and the current maturities are being reinvested at higher interest rates.
CAPITAL LOSS HARVESTING
One of the unique facets of our firm’s investment management is our continual monitoring of opportunities to capture income tax benefits for our clients. We are very active in ongoing harvesting of unrealized losses in our clients’ taxable investment accounts to reduce current and future income taxes. Most investment firms, if they do capital loss harvesting at all, restrict this to a year-end activity. We have our investment team monitoring loss harvesting opportunities throughout the year. The benefits of these efforts do not necessarily show up in our clients’ investment portfolio returns, but certainly do at tax time.
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The stock and bond market downturns earlier in February did yield some of these opportunities. Some of you might have noticed this activity in your non-IRA accounts. We do have to avoid “Wash Loss Sales,” which prevents us from recognizing the capital losses for tax purposes if we have purchased the security within a 30-day window before and after the sale takes place, so that did prevent us from capturing losses on some positions that were just purchased during January.
It is important to note that while we do sell these positions to harvest the losses, we do simultaneously purchase new positions in other holdings that should (and did) participate in subsequent market rallies.
REDUCTION OF SPECULATIVE EXCESSES
While our firm does not give financial market pundits much credibility in general (see Kyle Thompson’s recent blog on Market Noise ; there is some truth in comments that you will occasionally hear about a short-term market correction being good for the stock market. The reasoning behind this is that some market short-term speculators (as opposed to long-term investors) will be driven from the market during short-term market corrections and reduce the pent-up pressure in the stock market that could lead to much larger market declines caused by too much euphoric risk taking from the speculators.
So what is an investor to do during these times of market declines? I would refer you again to my Partner, Kyle Thompson’s blog on Market Noise, and also to rest comfortably, knowing that our firm is looking for opportunities to take advantage of capital loss harvesting and the reinvestment of your bond portfolios at higher rates of interest.