This Could Stop the Stock Market Rotation in Its Tracks

The stock market was choppy once again on Friday, continuing a recent bout of volatility. Early in the day, stocks gained considerable ground as investors seemed to write off the declines from last week as a short-term correction. Yet major indexes lost steam near midday. The Nasdaq Composite ended the day lower, and the Dow Jones Industrial Average (^DJI -0.98%) and S&P 500 (^GSPC -0.46%) were well off their highs by the close.

Today's stock market

Data source: Yahoo! Finance.

Looking at the way the various market benchmarks are behaving, it'd be natural to assume that investors are trying to rotate away from big winners like the tech sector into harder-hit areas offering good value. But as the end of the year approaches, there's a factor that could put a stop to that sector rotation.

Tax planning and the stock market

Markets often become volatile in the latter months of the year. We've seen plenty of market crashes come in September and October. In recent years, more-modest pullbacks have come in December.

There are plenty of factors that try to explain seasonal movements, and the data isn't entirely convincing. Nevertheless, there's one phenomenon that does tend to have an impact on individual stock prices near the end of the year. It has to do with investors trying to capture a tax break.

Image source: Getty Images.

Specifically, tax loss harvesting is a strategy that anyone can use to reduce taxes. If you have losses on your stocks, you can sell them and claim the loss against any capital gains you have on other sold positions. If you have more losses than gains, then you can take up to $3,000 in losses per year and apply them toward other types of income, such as interest, dividends, or even wage and salary earnings.

In order to take advantage of tax loss harvesting, you have to sell your losing stock. Moreover, you have to do it by Dec. 31, or you won't be able to claim it on your 2020 tax return.

Winners keep winning, losers keep losing

2020 is shaping up to be an odd year for tax loss harvesting. That's because different areas of the stock market have seen much different performance throughout the year.

Just looking at sectors, you can see the huge disparities. The Technology Select Sector SPDR (XLK -0.22%) is up more than 35% year to date, with giants like Apple (AAPL 0.52%) leading the way. Consumer stocks have also done well.

On the other hand, big portions of the market have gotten crushed. The Energy Select Sector SPDR (XLE 0.46%) is down nearly 40%, as oil prices have suffered from the disastrous impact of the coronavirus pandemic on economic activity across the globe. That's pushed many energy companies to the brink of failure, and even well-established oil and gas giants are feeling the pain. Similarly, financial stocks have taken a hit, falling nearly 20% so far in 2020.

For a rotation to take hold, investors will have to sell tech stocks in favor of hard-hit energy companies and banks. Yet if you're looking for losers to reap tax losses, you'll end up having to sell those same energy and bank stocks. You'll want to avoid selling your winning tech stocks, because that'll create gains that will boost your tax bill.

Taxes are only a small part of what moves the stock market. Yet saving on taxes is definitely a factor in investors' decision-making. That could cut short the apparent rotation we've been seeing in the markets lately.