Realizing Gains Is Like Managing a Garden

Doug Walters, CFA

Rising equity markets have introduced sizeable capital gains in many portfolios. Much like an overgrown garden, some of these gains need to be pruned to maintain the long-term health of your portfolio.

Contributed by Doug Walters, David Lemire, Eh Ka Paw, Max Berkovich

Spring is well underway, and if you are like me, you have been spending some time tending to your landscaping and flower gardens. As I admired the new growth and marveled over the fact that the butterfly bush I once thought dead was now a prominent feature in the garden, I also realized it was getting too crowded. The once tiny hostas are now sprawling and choking out the smaller plants. The weigela had outgrown its allocated spot and was intertwined with the turtleheads. It is time to rebalance for the long-term health of the garden!

Like a flourishing garden, when stocks rally for long periods, your portfolio will get out of balance. That is why we rebalance. We give each asset some healthy leeway to grow, but when it becomes too large, rebalancing is necessary to maintain the appropriate allocation to risk. And with rebalancing comes realized capital gains and their dreaded taxes.

Capital gains are a necessary evil of a successful portfolio. We often have clients ask us to limit their realized capital gains. In some circumstances, that may make sense. But in most cases, that is a risky proposition. Avoiding gains means letting your portfolio drift from its target risk allocation. Over time, that drift can become an unmanageable chasm.

Put this way, any decision to limit capital gains is a conscious decision to add risk to the portfolio over time. The cost of the gains must justify the added risk. For long-term investors, the risk is generally not justified. Half maintaining your garden is not going to cut it. You’ll invite the risk of disease and overcrowding. Likewise, regular, unrestricted maintenance of their portfolio is the best approach for most investors.

In the past five years, the S&P 500 has produced a total return of close to 100%. Small-Cap, Developed International, and Emerging stocks are all up significantly. These are good times for investors. For the most part, losses have been harvested, so any portfolio rebalance is likely to lead to realized capital gains and the associated taxes. While no one likes to pay taxes, they are inevitable in a rising market. Let’s enjoy these taxable gains! They are much better than the alternative – poor portfolio performance and losses to harvest.

$643,714

Fun fact – back in the 1600’s there was a tulip speculative bubble (“tulipmania”) in the Netherlands where single tulip bulbs sold for more than a mansion on the canal. Based on reports and our calculations, some may have sold for over $600K in gold in today’s dollars.

Headline of the Week

Something for Everyone Part II – Employment Edition

A strong jobs number plus higher unemployment equals some confusion.

Once again, an economic report sprinkled in the good with the concerning. The headline jobs number was considerably above expectations. That news, combined with average hourly wages ticking higher, had markets recalibrating when rate cuts might possibly start (especially given that Europe began to cut this week). However, the unemployment rate touched 4% for the first time in over two years, hence the “confusion.” We will spare everyone the arcane details on the various surveys that produce these numbers. Suffice it to say the dichotomy isn’t that unusual or concerning (yet).

The Fed meets next week, and we will get the next inflation report (see below), so it looks like this section could be a trilogy (if not Star Wars-esque in episodes).

The Week Ahead

We can safely divide next week into the Fed and everything else.

The Fed

After a two-day meeting on Wednesday, we will get the rate decision and a press conference from the Chairman.

The odds are that the Federal Reserve will sit tight at this meeting, and market-implied odds have now moved cut(s) out to the back end of the year after Friday’s jobs report.
There will be updated economic projections from the central bank and new “dot plots.”
With the Bank of Canada and European Central Bank cutting rates this past week, the heat is on Chairman Powell & Co. to not deviate too far from our trade partners to avoid any unintended consequences for the greenback.
Economic data has started to soften… well, except jobs data. And the calendar is beginning to tighten the window on rate cuts, so a lot hangs on the press conference commentary.

Everything Else

There is a parliamentary election for the European Union, a Gross Domestic Product (GDP) revision from the UK, and a rate decision from the Bank of Japan (BOJ). At home, we get an inflation report and something special from Apple.

The BOJ will have to jump in at week’s end and try to upstage the Federal Reserve, which is highly unlikely, as recent economic data will most likely keep the BOJ with near-zero rates at least for another month but may taper its bond purchasing none the less.
The United Kingdom will have a revised GDP and a Purchasing Managers Index reading, which should add fodder ahead of the July 4th election.
Parliamentary elections in the European Union may not be a game changer in any way for financial markets; however, the rise of right-wing support will be watched closely.
Apple Inc. has a Worldwide Development Conference next week, and expectations are high for iOS 18 to be “groundbreaking” with its AI use.
Lastly, CPI inflation results may come a little too late (early that day) to impact the Federal Reserve, but investors will want to see further progress on taming inflation.

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