Ride a Down Wave & Avoid the Potential Big Tax Bill (Update)
Observation From the Investment Boat — Volume 4, Issue 1
By James Mahnke, CIO & Portfolio Manager at GAMMA Investment Management LLC
December 31, 2020
Riding market waves in your investment boat can be beneficial over the long term. Take the longest bull wave in US history as well as the current bull wave denoted below—if you stayed in your investment boat during these incredible bull waves you likely earned over 4 times in equities.
Bull Market Waves for S&P 500 (%)
- 2009 — February 2020 400.5%
- March 2020 — December 2020 67.9%*
Source: Yahoo Finance; price gains computed from the respective lowest closes of the last two bear markets to their corresponding absolute closing highs; the current bull wave may continue beyond December 31, 2020*.
But, as you are aware, waves go up and then down and repeat with varying degrees of magnitude. The question now is whether the wave up from March 2020 is going to further accelerate with the distribution of COVID-19 vaccines, plateau or correct with a gut-wrenching decline in 2021. If vaccines are successful, people who have waited or stopped doing normal activities will return to movie theaters, dentist offices, etc. That is, there is a huge amount of pent up demand that will springboard consumer behavior once people are inoculated and feel safe. Such a springboard should continue to support the market rally since March 2020. Yet, if this springboard causes inflation to jump materially higher than the Fed 2% target for an extended period, there are some who foresee a spike in interest rates. Couple the spike with elevated levels of global debt and your upcoming boat ride over the next couple years may be filled with serious indigestion from volatile market waves. In that regard, do not get unnerved. Observe and respect that bear market waves can materialize if rates, debt and/or tariffs cause detrimental economic imbalances after such terrific bull waves.
Bear Market Waves for S&P 500 (%)
- February 2020 — March 2020 (33.9%)
- 2007 — 2009 (56.8%)
- 2000 — 2002 (49.1%)
- 1987 (33.5%)
- 1929 — 1932 (82.7%)
Sources: Yahoo Finance; price loss computed from the respective highest close of the last bull market to its corresponding absolute closing low as well as Yardeni Research and Investopedia.
If you believe a material down wave has begun, should you get out of your investment boat and sell equities now? Likely “Yes”, if your unrealized gains are small. But for those who have sailed these bull waves since 2009—maybe “No”, consider not selling as you likely have sizable unrealized gains and will get hit with a significant tax bill by selling.
To avoid the potential large tax bill, consider adding bona fide hedges to your portfolio to protect against a down wave. A small amount of capital or percentage of your portfolio can be used to execute hedges that intend to make money when markets fall, offsetting the decline in value of your core holdings that currently have the large unrealized gains; this pair-off of hedges and core holdings essentially keeps your total portfolio value near a desired level as a perfect hedge will gain $1 for each $1 loss in your core holdings. Pursuit of perfect hedges can be difficult as liquidity and execution issues can pop up as the market moves quickly, especially in a crash. But, having protection is better than no protection if the down wave is dramatic. In particular, you can buy long puts and put spreads or sell call spreads most likely on actual holdings in your portfolio. For institutional and other accredited investors, forward contracts, swaps, and futures can also be executed in addition to options to create the desired expected risk/reward over varying horizons, not just in equities but also in fixed-income and alternative asset classes like commodities.
There is also beneficial tax treatment for gains/losses when using hedges to manage not only expected risk/reward but also your overall pairing of gains with losses with the core holdings in your portfolio to create the most efficient tax result. But, maybe the most important benefit is that hedges can be rolled and removed without changing the core holdings in your portfolio—allowing you to stay in the market. Especially, if you would decide to start hedging today and tomorrow the market reverses and begins another bull wave. If such a reversal would happen, using a fully-covered option hedge has the clear benefit as the cost (risk) is limited to a certain dollar amount. That means if the market keeps climbing at some point your core holdings will gain more than you spent on the option hedge. Whereas, if you use forwards, swaps, or futures, the hedge continues to lose incrementally matching the gain on your core holdings—that pursuit of the perfect hedge essentially got you out of the market.
If the market would “sleep” having very little volatility, buying long only options can be expensive as the premium decays; buying and selling option spreads can alleviate that problem. To see how option spreads may be preferential, use horizon analysis to identify optimal positions for various changes in implied volatility, price and time. Horizon analysis can also show how rolling option hedges can not only protect but add tremendous value without relying on market timing.
In sum, bull market waves are subsequently followed by bear market waves. If you believe a painful bear market wave is beginning, consider not selling your core holdings with large unrealized gains to avoid a big tax bill. Instead, ride out the waves in your investment boat and capitalize on market volatility by using fully-covered option positions to hedge and to add incremental value with inherent asymmetrical return patterns.
This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and by James Mahnke, CIO & Portfolio Manager at GAMMA Investment Management LLC. Data comes from the following sources: Star Tribune, Bloomberg, Yahoo Finance, Wall Street Journal and any other public economic and financial resource deemed to provide relevant information. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.