Explaining the Crash: Did the Financial Media Miss Something?

If you had taken only a cursory glance at the news over this past weekend, you would have been struck by the confusion that apparently is in the minds of many regarding Friday's dramatic stock market fall. In fact, ever since March, financial analysts and Wall St. observers have been at a loss to explain the dramatic sell-off of stocks on the financial markets. Some have claimed the market has fallen because Internet stocks are over valued, and others have stated that the market is simply due for a correction. Still more chime in that the Microsoft ruling is to blame. But could it be that all of the above are incorrect or only tangential and that a more obvious cause is to blame? Could it be that the market is falling due to a much more basic and mundane reason?

Economist Jude Wanniski, president of Polyconomics Inc., believes so and since March has been advising his clients that the stock market may be falling dramatically because investors are "tax-selling" or selling stocks in order to pay tax obligations before today's filing deadline with the IRS. Because individuals have bought stocks and sold them within one-year they are responsible for paying capital gains taxes on their stock earnings. And because brokerage firms do not automatically withhold such taxes and send them to the IRS, individuals must keep track of their earnings and pay the capital gains tax all on their own. Wanniski, rather persuasively argues that many investors waited until the last minute to calculate their capital gains taxes and have been forced to sell even more stock in order to pay such taxes.

It is no surprise that individuals wait as long as possible to decide to pay their capital gains taxes. But it has been a surprise to many that these taxes have been larger than in previous years, due to the incredible performance of the stock market. Because of these higher earnings, higher taxes must be paid and many investors are finding that they do not have enough money in their personal savings to cover their capital gains tax liabilities. Therefore they have been forced to sell more stock that they own in order to obtain quick cash that they can forward to Uncle Sam by today.

Here is an excerpt of a March 30 "brief" that Wanniski sent to his Polyconomics clients, which are made up of institutional investors, Fortune 500 companies, high net worth individuals and several small individual investors. He wrote:

There must always be at least one reason for a sharp market sell off or a stock market surge. The NASDAQ sell off has me thinking of a connection to April 15 and the fact that there is no withholding on capital gains. There was a sell off last year too, remember, with a bounce back after April 15 and a flat market for some months thereafter. In other words, people who took cap gains before December 31 now find they owe Uncle Sam and must sell equities for that purpose. As they see the market slide, they know they better sell sooner than April 15 or wind up having to take deeper losses this year...

Then in a "brief" last Friday, April 14th, the day of the largest drop in the history of the stock market Wanniski wrote to his clients:

If I had been wrong in my March 30 hypothesis that the market was selling off because of millions of Americans scrambling to pay tax liabilities on their huge 1999 capital gains, today would have been a nothing day…There is now no doubt in my mind that this sell off has been almost entirely a result of the tax consequences of 1999. Which means we've hit bottom, as there is no way taxpayers can sell stock on Monday to meet 1999 tax liabilities, even with extensions on filing.

This situation has never confronted the stock market…ever. Which is why it is such a surprise to the world. In earlier periods of history, where there have been paradigm shifts from Old Economy to New Economy, tax rates were much lower. The transition from brick-and-mortar enterprise to a street-of-dreams was also extended over several taxable years. The folks who were cashing in last year on their gains, to buy this or that or pay estimated quarterlies, of course believed they would be able to sell off a little of this and a little of that in March and April to meet their tax liabilities. It is human nature. The market can't discount this kind of behavior.

When Wanniski wrote his March 30th memo he immediately received a response from a money manager who is a client of his. This particular client stated that for several days institutional investors weren't big players in the market and that trading volume was "suspiciously" light in comparison to other days when the market has suffered similarly steep falls. The client reasoned that the explanation had to be the retail sales of stocks. Retail sales are sales of stocks made by individual investors. It is these individual investors that Wanniski has identified as most likely to be selling stocks in order to generate cash to pay their taxes. This client had confirmed that Wanniski's analysis made more sense than the explanations that were dominating the financial media and which were circulating among investors throughout Wall ST.

So far, not a single major media outlet -- TV, print or Internet --has picked up on the "tax-selling" explanation to the stock market drop. But hindsight is always 20/20 so there still remains an opportunity. Today's events on Wall ST. and how they are reported should be rather interesting.

Cedric Muhammad

Monday, April 17, 2000