We have been getting a lot of calls lately about tax-loss selling and where do we go from here, so for this CHF eNewsletter issue, we have decided to share with you our analysis of the current market situation.
The TSX Venture index has been trading in a range from 760 to 800 in recent weeks. Throughout most of this year the Venture index traded between 900 and 1,050 and began declining in September. Some of that decline can be attributed to the reduction in gold and silver prices as the Venture Exchange has more gold and silver companies than all the other commodity and non-commodity companies combined.
The other major issue that has negatively impacted the Venture Exchange and its equities in the past six weeks has been tax-loss selling. In most years, tax-loss selling is usually done in November and December and has to be completed by the end of December (trading deadline this year is Dec. 24th 1 pm ET).
Charting for S&P/TSX Composite Index (top) and S&P/TSX Venture Composite Index (below):
This year a large number of financial advisors have told us that many of their clients are taking their tax losses now and have done so in the past few weeks as opposed to waiting for November or December.
Many investors locked in some large capital gains as they sold their banks, utilities and energy stocks earlier this year. If the gains are in their registered accounts such as a RRSP and a TFSA accounts, then capital gains do not apply. In cash and margin accounts however some investors have incurred large gains. They also have high marginal tax rates which can result in a sizeable tax payment. According to these financial advisors, most of their clients have losses in small cap companies, especially in mining and oil and natural gas, and, as a result, they have sold those equities contributing to the weakness in the small and micro cap space. Some advisors admit that some tax loss selling does not always work out as well as planned.
One such example is Duluth Metals (TSX: DM) trading at $0.07 on Friday, Oct. 31st. On Monday Nov. 3rd it received a takeover offer of $0.45 per share (from Antofagasta [LSE: ANTO]) and as a result some investors who sold missed out on this major advance. This takeover also shows us that many equities are significantly oversold and their assets are worth much more than their current market cap, which then can result in a takeover at a much higher price.
We have had some people asking us to explain the various reasons that investors choose to do tax loss selling. The first case is an investor who has generated significant capital gains from their investments (property sale, bonds, and equity sales) and they sell those investments that generate a loss in order to reduce the tax that is owed. There are, however, other circumstances that can occur.
Some investors have told us that they are tax loss selling this year in order to attain a tax deferral. These individuals plan to sell their second residences and in most cases their cottages next year. Since 1981 the sale of a second residence initiates a capital gain. An individual can apply tax losses back three years or carry them forward indefinitely. Since the small and micro- cap equity market has seen significant declines this year compared to other years, some of these investors are selling now because they expect a better small and micro cap equity performance next year which means they may not have the same opportunity for capital losses next year.
Some other investors that we deal with have major capital gains from last year and they did not have losses last year. They are taking their losses this year and will apply those losses to last year’s gains and will get a refund when they file their 2014 tax return.
The last group of investors that we deal with have decided to sell some of their small cap equities with the view that these companies will not perform well in the near future and that they can buy an equity that they believe has more upside in the next year and can recover some of their losses.
The fact that many investors have sold their small cap companies early and many of them plan to buy these companies back will be a positive factor for the Venture Exchange. Investors must wait 30 days to buy back an equity that they sold for tax loss purposes or CRA will not allow the tax loss from the transaction. Our view is that most of the commodity prices will be higher next year and with these investors returning, the better small cap companies will have some capital appreciation.
The recent strength in the US dollar has resulted in many commentators and market observers to suggest that major declines in all commodity prices will continue for the foreseeable future. While the correlation between the price of gold and the price of silver to the value of the US dollar is very high, it is not the case with many other commodities. One has to look at every commodity on an individual basis given the differences in supply and demand that exist in each separate market. In addition, commodity markets continue to change. Fracking has changed the supply dynamics of oil and natural gas. Oil demand today is more closely correlated to the transportation sector and not the electricity sector. Yet many strategists still compare the price of oil to coal, uranium and natural gas when they talk about competitors to oil and that the lower prices of those commodities will lower the price of oil when in fact they have little or no relationship to oil prices.
The level of the Venture Index has reached the low of 2008. The Venture index had reached 2,400 in March 2011 and that was the near term peak for many of the markets. At that point in time it became apparent that the European debt crisis was much worse than had been expected. The TSX Index was at 14,100 and went down to 11,600 a year later, a drop of 25.6%. This year the TSX Index hit an all-time high a couple of months ago at 15,600 yet the Venture market has dropped to its 2008 level. Recently, a number of individuals in the media have suggested that the small-cap market is being driven lower due to extremely weak commodity prices. In fact some have stated that most or all commodities are back to their 2008 price levels. This statement is incorrect as only a small number of commodities are back to their 2008 price levels.
Gold, silver, oil, zinc, palladium, lead, copper, and frac sand are well above their 2008 price levels. In fact, the vast majority of commodities are much higher in price than they were 10 to 15 years ago. We believe that this idea that commodity prices are weak arises from the fact that a number of commodities reached their highest price levels in March 2011 and have not recovered back to those levels. But one should take a longer time horizon when analyzing the relative strength of commodity prices and thus we believe that at present most commodity prices are fairly strong. In fact we believe that the vast majority of the commodity prices will move higher in the next three to five years based upon our supply and demand forecasts.
As a result it is our view that the small-cap, mid-cap and micro-cap markets in the commodity sectors are significantly oversold. We recognize that some companies will struggle and some will cease to exist. Those companies that do not have a viable project, or can’t raise money, or are located in a difficult jurisdiction, or have no infrastructure should be avoided. On the other hand, we see companies that have excellent projects, cash on hand, infrastructure available, are in good jurisdictions, and have experienced management worth a closer look. We have been surprised that those companies that have all the requirements that we just mentioned and continue to achieve the milestones that they promised are, in most cases, trading at price levels similar to those companies that we think may not survive. Since we expect the small cap market to improve over the next few years we do expect investors to buy those companies that have superior assets and superior management teams.
The reduction in the last year of smaller brokerage houses has also been a negative factor for the small and micro cap markets. The mergers of some small firms and the closure of some other companies have resulted in fewer analysts and have resulted in many companies losing their coverage. The lost coverage results in fewer brokers following these companies. In addition compliance departments at brokerage companies (especially at the larger firms) also prefer to see research or valuation reports in order to justify small and micro cap purchases by brokers. At CHF we are helping to fill that void as we have been and continue to produce valuation reports for small cap companies. These reports are now being done by Mark Lackey who was a director of Research and a Strategist on Bay Street for 16 years. Many investment advisors that follow the commodity markets do agree with our assessment. A number of them in past few days have said to us that they think that in the next two months, once tax selling is over, it will be the best opportunity in the last 15 years to buy small cap and micro cap commodity based companies. In fact our view is that those investors who buy the best small cap and micro cap resource companies over the next few months will have superior returns relative to either the TSX Index or the Dow Jones Index over the next three to five years.
From present price levels, we expect over the next one to three years that the largest commodity price increases will be in zinc and uranium. Uranium has responded favorably to Japan’s news yesterday of starting two reactors. We also are projecting significant increases in oil, nickel, frac sand, palladium, iron ore and SOP (sulphate of potash). We expect moderate increases for natural gas, gold, silver, met coal, phosphate and copper.
— Mark Lackey is executive vice-president of CHF Investor Relations (www.chfir.com, www.chfcapital.com). This article originally appeared in the November issue of CHF Spotlight, CHF Investor Relations’ monthly enewsletter.
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