On Capital Gains & Losses Part V.3

Sometimes markets crash. That is they experience in a short period of time a violent negative price adjustment. We covered this originally in part IV of this series. {See link: http://lumencapital.blogspot.com/2009/06/on-capital-gains-losses-part-iv.html} Above I've placed a chart showing extreme market dislocations in the past eleven years starting with Long Term Capital Management in 1998. You can double click on this chart to make it larger. Prior to 1998 stocks experienced these kind of dislocations twice during the Great Depression, after John Kennedy was assassinated in 1963, in 1987 and in the fall of 1990 after Iraq invaded Kuwait.

Markets crash due to unforeseen outside events which rapidly overtake the system. They are I believe the hardest environment for investors. Part of this comes from the shock of seeing such a rapid decline of portfolio value in short periods of time and the feeling among both investors and professionals that in retrospect the issues that caused a crash look so obvious.

Thinking that the majority of investors can sniff out a crash is flawed logic. Markets are discounting mechanisms. They discount price by analysis and by making educated guesses on future events. When events can be foreseen then it is likely that markets have already incorporated this possibility into their pricing mechanisms. Let's put it this way. Last fall's violent market correction (over 30% in about two weeks) had less to do with the issue of mortgage defaults then it did with the government letting Lehman Brothers go out of business and the near failures of so many other banks. The issue of housing and mortgages was pretty well known by September. The market was already down over 10% back then. Most of the major bank indices were down more than 15%. Very few investors anticipated that the problem was going to morph into a situation where the survival of the banking system was in question. Markets would have corrected much earlier and maybe over a longer period of time if they had suspected what was to come. We've covered this point and investor's reaction to it in an earlier post on who got last year's crash right; http://lumencapital.blogspot.com/2009/06/who-got-last-years-financial-crisis.html .

Markets will crash in response to an unforeseen outside event. For example if we wake up tomorrow morning and find that there has been an major earthquake in Southern California or that a giant asteroid will hit the earth next week or that North Korea has dropped a nuclear missile on South Korea then expect to see a pretty violent and rapid market correction. Since none of these events are expected, markets will not have had time to discount their possibilities and their initial reaction will be to panic by removing liquidity {selling}. They will do this until prices can discount what these events might mean to the economy. Then they will stabilize and often experience a rapid return in pricing once the event is priced in. This happened during the First Gulf War. Stocks corrected about 15% in a 5-6 week period in the fall as the world reacted to Iraq's invasion of Kuwait. Prices stabilized once markets gained confidence that Iraq would not be permitted to invade Saudi Arabia and experienced a rapid price increase when the Allies unleashed Desert Storm.

Markets will also crash when there is a shock to the financial system. These events often occur when a major financial institution collapses. Crashes like this occurred in 1911, 1929, 1932-33, 1987, 1998 and 2008. In the modern world such events usually prompt massive governmental intervention such as we are currently seeing.

Here is the Playbook for dealing with market crashes. The first thing is to understand that it is almost impossible to anticipate 100% such an event. Warren Buffett owned lots of stocks last fall. He still does by the way and added to his holdings at the end of last year. Hopefully, the events do not occur in such a vacuum that you haven't been able to play defense in your portfolio. Even so, unless you are 100% in cash you will have been savaged by events like last fall. For example we had higher than normal cash positions in almost all of our accounts last fall but we still experienced the pain just like everybody else. As I've often said since then, our systems are designed much like the pumps on a ship to remove as much water as possible from the bilge during a storm. However, no system will keep the boat from sinking when the bottom is ripped away. Last fall was one of those times.

You must begin by reassessing the present situation after a crash with your own risk tolerance. Then the portfolio needs to be restructured to take into account any changes in risk tolerance to remove investments that either will not perform going forward or to lower that exposure to risk. This is already a pretty lengthy post so the reasons for remaining invested in stocks will have to be discussed at some other time. However, assuming you are staying committed to equities in some form, then portfolios should be restructured over time to lower the cost basis of the assets that you want to continue to own. This should be done even if this means taking large investment losses! As we have indicated at the beginning of this series the losses have already occurred. Nobody wants them, but after a crash and after our investment environment these past 10 years, it is likely they will be in your portfolios in some form or the other. As we have stated, they can be used to an limited extent versus ordinary income and current law states they can be carried forward to lessen the impact of any capital gains going forward. Thus they need to be incorporated as a prudent part of the portfolio management process going forward.

If economic history holds the same, then at some point the economy will again grow and stocks will again be a representative way to participate in that growth. Most of us will want to use accumulated losses to offset future gains that should come when the economy recovers.

One last thing about crashes. They usually herald the end of some era. That is they usually signal that things both financial and social will be different going forward. The crash of 29 signalled the beginning of the Depression. The end of the Dot.com boom in 2000 told us that technology would not be the market leader going forward. It is likely that last years crash is signalling some sort of change like this. That is why we are calling this era the "Great Reset". We'll discuss this and what it means for investments much more in the coming months.

*We are covering in this series what we believe is the proper procedures regarding the application of capital losses for investors at Lumen Capital Management, LLC. If you are not a client of our firm you should either do your own homework or consult with your own investment advisor before implementing any of these strategies listed in these posts. Also you should consult your own tax professional before implementing your personal strategy for capital losses. This series is a general overview and should not be considered personal tax advice of any kind. Please note as well that tax laws could change in the future which could impact the implementation of these strategies or negate some or all of the advantages of harvesting capital losses. Finally you should be aware that we have not covered all of the possible risks to which ETFs could possibly be subjected. When discussing the risks regarding ETFS, we have no knowledge nor do we make any guarantees whether some of the same issues and risks particular to equities could ultimately affect ETFs as well. Again please consult your own investment advisor or do your own homework as to the appropriateness of these investments for your portfolio You can also visit any of the popular ETF websites for a further discussion of this topic.

Next week a brief review of the basic & pertinant rules on taking losses. In the final post of this series we will discuss what you do tactically in portfolios to address these losses.