Why a Wave of ‘Forced Selling’ Could Hit the Markets Next Month
This week’s Money Talks is a little different.
In place of my usual editorial, I’m sharing a guest essay from Inside TradeSmith editor Justin Brill. It highlights a potential risk to the markets (and your retirement accounts) over the final weeks of the year that I think every reader should be aware of.
As always, if you know someone who could benefit from these ideas, please share this email or encourage them to sign up for Money Talks (for FREE) right here.
All the best,
Keith
Why a Wave of ‘Forced Selling’ Could Hit the Markets Next Month
In Inside TradeSmith, I’ve urged readers to remain conservative with their investment portfolios for the past several months.
The reasons are simple and straightforward…
The Federal Reserve continues to aggressively raise interest rates. The broad stock market is still trading at historically expensive valuations. And most importantly, our powerful TradeSmith tools have not yet triggered new buy signals in the major market indexes.
Until one or more of these things begin to change, most stocks will likely continue to struggle, despite any temporary bear market rallies along the way.
However, I recently shared another short-term risk that could put even more downside pressure on stocks into year-end. It has to do with the estimated $21 trillion held in 401(k)s, individual retirement accounts (IRAs), and other qualified retirement plans in the U.S. today.
As you may know, these plans carry a stipulation — known as the required minimum distribution (RMD) — which requires investors to withdraw a minimum amount of money from their accounts each year once they reach 72 years of age (raised from 70 ½ in 2020).
The Internal Revenue Service (IRS) determines the amount of these withdrawals based on the total value of the account and the participant’s life expectancy.
RMDs generally start at around 4% of the account’s value each year but can rise to well over 15% over time. And because these accounts typically don’t offer cash vehicles, investors generally must sell assets (stock or bond funds) to meet this requirement.
Investors can take RMDs for a particular tax year any time between Jan. 1 and Dec. 31, so this selling hasn’t historically had any predictable impacts on the markets. However, a confluence of four specific factors suggests that this year could be an important exception.
Factor 1: A Huge Wave of Baby Boomers Are Now Qualifying for RMDs
The first members of the “baby boomer” generation — which includes folks born between 1946 and 1964 — turned 70 in 2016 and 72 in 2018. That means even after the recent increase in the RMD age in 2020, more and more of these folks are now having to make these withdrawals each year.
That is noteworthy for two reasons.
First, the baby boomers are the second-largest generation in the U.S. today, accounting for more than 21% of the population. (Only millennials — born between 1981 and 1996 — are slightly larger.) Americans older than baby boomers account for just over 6% of the population by comparison.
Second, the baby boomers were the first generation to make significant contributions to these types of retirement plans, and they currently hold more investment assets than any other.
In fact, according to data from the Federal Reserve, they own roughly 52% of all household wealth in the U.S. today. That’s more than every other generation combined.
In other words, we are now beginning a massive increase in annual RMD-related selling that will likely continue for the next decade and beyond.
Factor 2: Impending RMD Deadline
As I mentioned, investors can take RMDs anytime between Jan. 1 and Dec. 31 for a given year. However, if an investor doesn’t take an RMD by year-end, they are subject to stiff tax penalties.
This situation is most common among those who have just reached the minimum RMD age and don’t realize — or have forgotten — that they’re required to take a distribution, or when poor market conditions may delay selling earlier in the year (more on this in a moment).
Administrators typically notify participants of this deadline by early December to ensure ample time to complete the transactions. And in some cases, administrators may even initiate a distribution on a participant’s behalf.
Factor 3: RMDs Are Based on Prior-Year-End Account Values
Again, the IRS calculates RMDs using an investor’s account value and current age. However, it’s important to understand that the former figure refers to the account’s value at the end of the prior year.
That means market performance can significantly impact the actual RMD investors must take.
As a simple example, suppose an investor’s account was worth $100,000 on Dec. 31 of the prior year, and based on their age, they are required to take a $5,000 (5%) distribution.
If the market has a great year and the account value rises to $125,000 at the time of the RMD, that $5,000 distribution would actually only require the investor to sell 4% of the assets in the account.
However, if the market struggles and the account value falls to $75,000, that same $5,000 would represent nearly 7% of the assets in the account.
These changes may appear insignificant, but they could represent a huge difference in selling pressure when applied to a large population.
Factor 4: This Was a Historically Bad Year for Stocks AND Bonds
Most folks know 2022 hasn’t been a great year for the stock market. The benchmark S&P 500 Index (SPX) is currently down around 17% for the year (and was down more than 25% at its October low).
But you may not realize it’s been an even worse year for bonds. Various bond market benchmarks are currently down anywhere from 15% to 30% year-to-date.
This combination is highly unusual. Since at least the 1950s, stocks and bonds have been somewhat “inversely correlated,” meaning bonds have tended to do well when stocks have struggled and vice versa.
This relationship is the basis of most traditional retirement portfolio strategies, like target-date funds or the “60/40” portfolio (60% stocks/40% bonds).
The terrible performance in both stocks and bonds this year means these strategies have had their worst year in history. The typical 60/40 portfolio is currently down more than 22% year-to-date.
A loss of this size is practically unheard of, even during the worst bear markets. For comparison, these portfolios generally lost no more than 15% to 20% in 2008, when the SPX plunged nearly 40%.
This Combination Could Create a Wave of Additional Selling Next Month
When you consider these factors together, the implications are concerning.
In short, there is a larger-than-usual number of folks — holding an outsized percentage of stocks and bonds — who could be forced to sell a larger-than-usual amount of their investments over the final weeks of the year.
Of course, this scenario doesn’t guarantee the market will fall next month. But it is likely to be a significant headwind, and it could dramatically ramp up selling pressure if the bear market rally of the past several weeks begins to fizzle out.
In any case, if you’re among the folks who still need to take an RMD from your retirement accounts before year-end, I would encourage you to take advantage of the recent rebound in stock and bond prices to sell some assets before December begins.
Given the risk of further downside in stocks, I’ve also heard from several Inside TradeSmith readers interested in “short selling” or otherwise betting against stocks.
However, profiting from these kinds of bearish trades is difficult. As we’ve experienced this year, bear market rallies are often just big enough and long enough to convince investors that the worst is over, and a new bull market is underway. And most folks ultimately give up on their bearish bets just before the bear market resumes.
So, my general advice for most investors has been to simply hold cash and wait for new buying opportunities… and if you are going to bet against stocks, to only do so with money you can afford to lose.
That’s still great advice for conservative investors. However, I’m pleased to announce that we’ve just launched a brand-new set of tools to make betting against stocks more accessible — and more profitable — for individual investors.
In short, these tools are designed to identify “pre-crash activity,” which often appears in stocks that are at risk of plunging, weeks or even months in advance. This can dramatically improve your odds of success when shorting stocks.
We officially introduced these powerful new tools in a special online event on Tuesday. If you missed it, you can learn more about how they work — and how you can try them for yourself — right here.
Regards,
Justin Brill
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