Creating Opportunities In A Market Correction: Rebalance, Roth, And Crypto

The market has started to create a ‘correction’ or a 10% decline. As of January 24, 2022, the NASDAQ was in correction, the S&P 500 was down about 11.1% (from January 3), and many crypto currencies are down as much as 50%. In addition, many stocks are fully off their highs. Down markets can be psychologically painful but can also provide significant opportunities.

History tells us that the markets follow a relatively repeatable cycle of runs and declines. Since 1950, there have been 37 declines in the double digits (probably 38 by the end of January 2022). Ten of those declines have been more than 20%, which is commonly known as a ‘bear’ market. The data in the chart below shows the period of peak-to-trough and the number of days between corrections.

All previous corrections/bear markets have been followed by a recovery. Please note that there is no way to determine the ‘bottom of the bottom’. There is, however, some opportunities presented during down cycles. The way you embrace or reject these opportunities might depend on whether you view a correction as a time to run or a time to rise. Here are three ideas to consider:

Rebalance. One logical action in a down market is to rebalance the portfolio. Rebalancing based on market conditions is considered tactical. Portfolios are usually strategically allocated to a percentage of stocks, bonds, and cash. Typically, a portfolio is rebalanced or set back to its determined percentages on a periodic basis. For example, an investor might have allocated their portfolio 70% to stocks, 25% to cash and 5% to cash on January 1, 2022 with the intention of rebalancing at the end of the year. Suppose the portfolio, given the decline in both stocks and bonds, is 67.8% stocks, 26.7% bonds and 5.5% cash.  A simple rebalance would move 2.2% from bonds and cash into stocks.

Another approach is to modify individual ingredients. For example, perhaps the investor wants to take an inflation-defensive approach, so they might ‘tilt’ to small caps, or real estate, or TIPS. This same rebalancing approach might be achieved through contributions to the portfolio. If an investor is adding monthly to their 401(k) for example, they might tilt their monthly contributions exclusively to equities. An investor could similarly do a ‘swap’ and swap a bond fund for a small cap fund to bring the portfolio to balance.

Roth strategies. Another strategy in a down market is to fund Roth options in a down market. Roth options are notable for some unique features:

·       Qualified distributions are tax-free

·       There are no Required Minimum Distributions (RMDs) to the original owner or spouse

·       The assets can be distributed to heirs up to 10 years after the death of the owner and their spouse

Roths can be funded through contributions, like contributing to a Roth IRA (or ‘Back-door’ Roth), contributing to a Roth 401(k), using a ‘Mega-Roth’, or by converting a conventional IRA to a Roth. Funding a Roth in a down market offers more tax-free traction as the market returns. This can be particularly true of an investment like a stock or fund which can be converted in-kind to a Roth. Thus, if an investor has a favorite stock that is in correction mode in their traditional IRA, they could transfer that stock to their Roth at the low price, pay the taxes on the income at the time of the conversion, and have all subsequent gains accrue tax-free.

Crypto. January 2022 has been a brutal month for Crypto currencies. Crypto owners may find somewhat of a silver lining by employing a special tax rule for crypto currencies. With most investments, there is a ‘wash-sale’ rule, prohibiting the deduction of a loss of as security that has been replaced with an identical security within 30 days. Crypto currencies are not subject to the wash-sale rule. A crypto owner with Bitcoin in a taxable account purchased on November 5, 2021 at around $65,000 might find it down around $36,000 in late January. They can sell their lot from November, and immediately buy it back, realizing a $29,000 loss. That loss can be offset against other gains in taxable accounts. Note that the repurchase could happen through a Roth IRA, thereby making the subsequent gains potentially tax-free.

Bottom line. Market corrections are a normal part of the market cycle. While we have no way of knowing when a ‘bottom’ occurs, doing a sideways step by rebalancing, converting to a Roth, or harvesting losses can create opportunities out of adversity. As always, I’ll try to answer questions: llabrecque@sequoia-financial.com.