Depending on what you invest in, this may be a year where you both incur a loss of portfolio value and owe capital gains taxes. This is particularly true if you hold actively managed mutual funds in a taxable account. Even if you don’t hold mutual funds in a taxable account, the new tax law may have implications for you.

I’ll start with mutual funds. In an email sent out last week, Mark Wilson of CapGainsValet wrote, “We are breaking records (going back to 2014) for funds with 10%+, 20%+ and 30%+ distributions.” As of today, Wilson has counted 67 funds with estimated distributions in excess of 20%. Put another way, for every dollar of share assets, investors in these funds will receive distributions equating to $0.20 or more. The distributions are taxable if shares are held in a taxable account, even if the fund has declined in value and/or you’ve only held the fund for a short period of time.

The large distributions are the result of the long-running bull market. After a nearly 10-year bull run (though wobbling as of late), managers of actively managed funds have fewer losing positions to sell. At the same time, longer-term positions that no longer matched their strategies were more likely to have increased than decreased in value.

This put fund managers in a position where the only choice when it came to making a portfolio change was to sell a winner without having enough losses to offset the tax impact.

Some of you may be able to avoid paying taxes on the distributed long-term capital gains, and similar gains on other investments. The Tax Cuts and Jobs Act established a 0% tax rate on capital gains (and qualified dividends) up for married couples filing joint returns with taxable income up to $77,200 ($38,600 for single filers). Note the income limits; previously, the 0% rate applied to those who were in the older 10% and 15% tax brackets.

Capital gains and dividends count toward your adjusted gross income. Depending how close you are to the next bracket and the size of the capital gains realized, you could potentially face the double-whammy of paying a higher marginal tax rate and a higher capital gains rate. For those of you who are retired, capital gains can also impact how much of your Social Security benefits are taxed this year and what you will pay in Medicare premiums two years from now if they push you over certain thresholds. Adding Roth IRA conversions to the mix will also increase the odds of getting near or going over the thresholds for both working and retired investors.

Those of you with higher income levels will also face the possibility of paying the 3.8% net investment income (NII) surtax on capital gains and dividends. The tax applies to joint filers with NII and modified adjusted gross incomes above $250,000 and single filers with NII and modified adjusted gross incomes above $200,000. These thresholds are not indexed to inflation.

Gains can be offset by losses. To the extent there are losses to claim, you can not only negate a similar amount of gains but also reduce your adjusted gross income by up to $3,000 per year. You can also reduce gains when selling securities or fund shares if you tell your brokerage or mutual fund firm in advance which specific shares you want to sell.

At AAII, we do not believe the tax tail should wag the portfolio dog. Rather, we think you should make the best investing decision first and then deal with tax consequences afterward. There is a good amount of flexibility within this framework for those using both taxable and tax-preferred accounts. Tax-efficient assets such as index funds, long-term stock holdings and municipal bonds should be held in taxable accounts. Actively managed funds, corporate bonds and real estate investment trusts (REITs) should be held in traditional IRAs, Roth IRAs, 401(k)s and similar types of accounts. A simple rule of thumb is to hold the least tax-efficient investments in accounts not subject to capital gains and ordinary income taxes.

• An In-Depth Look at the Tax Consequences of Asset Location – The type of account chosen to hold an investment in impacts the aftertax rate of return you will realize.
  
• Keeping Transactions Clean From the Wash-Sale Rules – Avoiding violations of the wash sale rule can help you both claim losses and avoid tax headaches.
  

• The Individual Investor’s Guide to Personal Tax Planning 2018 – Our annual tax and financial planning guide has been updated to help you understand how the new law will impact your 2018 and 2019 taxes.
  
• 19 Year-End Financial and Investing Moves – These are actionable steps covering personal finance, estate planning, investing, retirement and taxes that investors should consider taking now.
  

Two S&P 500 index members are scheduled to report earnings: Adobe Systems Inc. (ADBE) and Costco Wholesale Corp. (COST). Both will announce their results after the market closes on Thursday.

The week’s first economic report will be the October JOLTS report released on Monday. Tuesday will feature the November producer price index (PPI). The November consumer price index (CPI) will be released Wednesday. Thursday will feature November import and export prices. November retail sales, November industrial production and capacity utilization and October business inventories will be released on Friday.

The Treasury Department will auction $38 billion of three-year notes on Tuesday, $24 billion in 10-year notes on Wednesday and $16 billion of 30-year bonds Thursday.

Pessimism among individual investors about the short-term direction of the stock market pulled back to its historical average in the latest AAII Sentiment Survey. Optimism and neutral sentiment both rose. As discussed below, timing played a role.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 4.1 percentage points to 37.9%. Even with this week’s increase, optimism remains below its historical average of 38.5% for the 11th time in 13 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 4.9 percentage points to 31.6%. The rise puts neutral sentiment above its historical average of 31.0% for the first time in six weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 9.0 percentage points to 30.5%. This is the ninth consecutive week and the 12th week out of the last 13 weeks that pessimism is at or above its historical average of 30.5%.

The survey period runs from Thursday through Wednesday. Reminders to take the survey are emailed to a rotating group of AAII members every Monday. Nearly half of this week’s responses were recorded on Monday, and the majority of respondents took the survey between Thursday and Monday.

Many AAII individual investors have not altered their strategies in response to the ongoing volatility. This is not universally the case, as there are some individual investors who have taken a more defensive posture. Cash allocations reached a 33-month high last month according to our November Asset Allocation Survey. Other than market volatility, influencing individual investors’ outlook are Washington politics (including President Donald Trump and the midterm elections), tariffs (particularly the ongoing trade war with China), corporate earnings, the Federal Reserve, valuations and concerns about the pace of economic growth.

This week’s special question asked AAII members what influence third-quarter earnings had on their outlook for stock prices. Responses were mixed. The largest single group of respondents (22%) indicate that their outlooks have not changed following the latest earnings announcements. About 16% describe earnings as reinforcing their bullish outlook. Nearly the same proportion of respondents, 15%, are paying more attention to 2019 earnings. Many of these respondents indicate concern about a possible slowdown in growth or an outright decline. Other respondents point to the trade war and slowing global growth (10%) or the pace of rate hikes and inflation (also 10%).

Here is a sampling of the responses:

• “I am optimistic at present, though I am wary of inflation and less earnings growth next year.”
• “Little influence. The market is being driven by other factors, especially trade.”
• “Not much. The market seems fixated on the Fed and tariffs.”
• “Positive and encouraging me to buy on dips.”
• “The bump from the tax cut is over, and comparisons will become more difficult going forward.”

Bullish: 37.9%, up 4.1 points
Neutral: 31.6%, up 4.9 points
Bearish: 30.5%, down 9.0 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Individual investors’ exposure to cash rose to its highest level in nearly three years last month. The November AAII Asset Allocation Survey also shows an increase in fixed-income exposure and a drop in equity allocations.

Stock and stock fund allocations fell 4.9 percentage points to 64.6%. Equity allocations were last lower in July 2016 (64.1%). The drop was not large enough to prevent equity allocations from staying above their historical average of 61.0% for the 68th consecutive month.

Bond and bond fund allocations rebounded by 2.5 percentage points to 15.8%. The increase was not large enough to prevent bond and bond fund allocations from staying below their historical average of 16.0% for the 12th consecutive month.

Cash allocations rose 2.4 percentage points to 19.6%. Cash allocations were last higher in February 2016 (21.3%). Even with the increase, cash allocations stayed below their historical average of 23.0% for the 84th consecutive month.

The increase in cash allocations follows the recent downward volatility in the stock market. Pessimism about the short-term direction of the stock market rose to what was nearly a three-year high in our AAII Sentiment Survey during the week of Thanksgiving. Higher yields on money market accounts and CDs may also be making cash a more attractive option for some investors.

Differences in which AAII members participate in the survey and changes in the value of their investments both affect the results of this monthly survey.

Last month’s special question asked AAII members what changes, if any, they made to their portfolios in response to this fall’s drop in stock prices. Almost two of out five respondents (39%) say they didn’t make any changes. Some say they are long-term investors, while others say they don’t react to short-term volatility or have previously adjusted their portfolios. Slightly more than 30% say they bought stocks, mutual funds or exchange-traded funds (ETFs). About 10% increased their exposure to cash, while 5% boosted their exposure to bonds. Not all AAII members who took the Asset Allocation Survey answered the special question.

Here is a sampling of the responses:

• “None. I try to avoid reacting to short-term volatility and stick with my long-term investment plan.”
• “Held steady. I’m not trying to time the market.”
• “I added to my dividend stock fund positions. As the market is temporarily down, I want to add additional shares.”
• “Booked some gains and added to my position in Treasuries. I’m going for safety.”

• Stocks and stock funds: 64.6%, down 4.9 percentage points
• Bonds and bond funds: 15.8%, up 2.5 percentage points
• Cash: 19.6%, up 2.4 percentage points

• Stocks: 31.1%, down 1.1 percentage points
• Stock Funds: 33.5%, down 3.8 percentage points
• Bonds: 3.4%, up 0.8 percentage points
• Bond Funds: 12.4%, up 1.7 percentage points

Take the Asset Allocation Survey.

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