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Equity investors may be just two trading days away from a possible pause or rebound  from the biggest December stock market rout since the Depression.

That’s because the tax loss selling that has contributed to the December drop will end when the year does.

How big a role those sales played in the market plunge, however, is not clear because there are many other reasons for the stock market slide including the government shutdown, slowing economy and Trump’s attacks on Fed Chairman Jerome Powell — which all could continue into the new year. But those tax loss sales have been a factor in the stock market slide, according to Nicholas Colas, co-founder of DataTrek Research.

“One underappreciated problem … is how many managers and investment advisors had to respond to this sudden reversal of fortune,” writes Colas about the December stock market drop, which erased year-to-date gains in major indexes, creating losses that could be used to offset earlier stock market gains.

He explains that money managers who had sold some large stock winners earlier this year as the market started to soften would want to offset those gains with losses because otherwise their clients in taxable accounts “will have to cut a large check to the U.S. Treasury in April 2019.” They’re likely to resent those tax payments “when there is no wealth effect of rising asset prices to soften the blow,” writes Colas

He estimates tax loss selling of $41 billion in December, which has been only partially replaced by offsetting ETF purchases of about $25 billion, based on data from ICI and XTF, but says “there’s no way to quantify” the sales.

The question now is whether the tax-loss selling continues. After  Wednesday’s 1,086-point (5%) rebound in the Dow following a four-day plunge of over 1,800 points, Colas said the question for investors now is whether the tax loss selling is done and whether markets are re-priced enough to attract more buying?

But midday Thursday, however, the Dow was down 2.5%, suggesting that “some part” of the drop “must be due to last bits of tax loss selling,” perhaps by investors who were disappointed that the rebound didn’t continue, Colas told ThinkAdvisor.

Less than an hour before Thursday’s market close, the Dow had recovered more than half the earlier losses and ended the day slightly higher.

—Related on ThinkAdvisor:


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