Use Your Tax Refund to Ride the Market Pendulum

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Spring prompts people to think about tree blossoms, outdoor activities and tax refunds. The average personal tax refund in 2015 was $2,893, according to the IRS.

If you have high-interest credit card debt or student loans, using your refund to pay them down would probably be the best investment you could make, given the interest you’re paying on these debts. If you don’t have these, you might contribute this money to tax-deferred accounts, such as a 401(k) or an IRA, to reduce your taxable income—assuming you haven’t or don’t envision reaching the contribution limit for tax deferment.

The next option (aside from spending your refund, which brings no income down the road), is to invest it. This option might strike you as ill-timed if you’ve been watching the herky-jerky stock market this year with your mouth agape.

But the flip-side of this positive: Some sectors are so beaten down that these stocks can be purchased cheaply. That is, unless, like too many investors, you prefer to wait for the market to improve and then buy high. Instead, you can get in when these stocks are out of favor and ride the pendulum back into the zone of investor favorability. The sector pendulum almost always swings back; it’s just a question of when.

Sure, you could end up waiting a while, but the rewards can be substantial if you are patient. This investing common sense was put to use by many when the market, depressed from the financial crisis of 2008, came back strongly over the following five years. Those who lost money during this period didn’t act so sensibly. They lost money in the market meltdown, then sat fearfully on the sidelines for a while, buying high when they eventually got back in.

The wise and patient folks who profited from the meltdown-turned-bull market know that when shares of household-name companies plummet in price -- yet their fundamental investing propositions remain intact -- there’s money to be made. In most cases, investors who want to get in on this but aren’t comfortable picking stocks can buy a mutual fund or exchange-traded fund (ETF).

The widespread perception that the market has a chronic disease provides opportunities that savvy investors can exploit—if they’re willing to wait for good returns. (This shouldn’t be a problem for long-term investors, which is what most individuals should be). Here’s a sampler of beaten-down categories:

  • Energy stocks

    Once a blue-chip staple, energy companies have become value stocks. A couple of years ago, this prospect would have been regarded as astonishing, given the reliability of large energy companies producing solid returns. Their prices have been pummeled—the S&P Energy Index is down 21 percent in the last year.

But given Western civilization’s penchant for driving cars, and China’s new thirst for oil, how long do you think sub-$2-a-gallon gas will last? Sure, you could wait a year or two for this sector to come up, but it’s best to do this while owning it since you can never be sure about timing. It’s true there’s a huge supply of oil right now, but demand is increasing. And according to economist Mohamed El-Erian, increasing demand is expected to dovetail with “incremental, massive supply disruption” to push oil prices higher “over a number of years.” Thus, energy stocks would gradually increase. You can tap into this expected growth through an energy sector ETF such as SPDR ETF XLE, which holds a slew of energy stocks. Or, if you’re into individual stocks, consider companies like Exxon Mobil Corp. (XOM), which, for some, is worth buying for the 3 to 4 percent annual dividend alone.

  • Industrial stocks

    Industrials are a broad category: Think of companies like GE, DuPont and Caterpillar. A good example of an industrial with great potential is Cummins Inc. (CMI), a leading manufacturer of diesel truck engines. The slowdown of economic growth in China has punished the industrial sector, and Cummins is no exception. China’s slowdown has hurt Cummins and other industrials, but the amount of freight being hauled in its global markets has increased overall. Potential investors concerned that their shares might languish can collect a nice 4 percent annual dividend from Cummins while they are waiting for a comeback in share price.

  • Small cap stocks—generally, those of companies whose total shares outstanding are valued at about $300 million to about $2 billion.

    This is a category that’s been shunned by the market in recent years but, like most things on Wall Street, today’s dog may be tomorrow’s star. If you don’t feel confident in your ability to identify the dog stars, you might consider one of various ETFs yoked to the Russell 2,000 index of small-cap companies.

  • Value stocks

    By this, I don’t mean big companies that are beaten up by the market this year, but stocks that have long traded at prices considerably lower than their fundamental characteristics would suggest compared with their peers. Value stocks fall into all market-size categories. Given the market’s attitude toward small cap and value stocks for the last several years, it’s no surprise that small-cap value stocks have been shunned while the attention has been on Facebook and Amazon. Professional investors generally don’t want to put the effort into researching smaller companies, so most of these shares are owned by individuals and indexes. Small-cap value stocks have long been stuck in the mud—down 5 percent in 2015 when the rest of the market was up slightly. If you believe in the likelihood of a value comeback in the next couple years – and I do – an easy way to position to benefit from this is to buy a small-cap value ETF. One example is IWN.

Focusing on these out-of-favor market areas takes a mentality foreign to those who run to buy a stock when they hear about its rise. Remember: If you hear about a stock at a party, you’re probably too late. That’s because the greed pendulum always swings too far. Well, the fear pendulum does, too. When fear takes over, prices go down, creating opportunities for those willing to wait until market perception catches up with the stock’s actual merits. And it’s much better to buy low and wait for a likely rise than to pay high and wait for a more likely decline.

One more thing you might do about that refund: Decrease your withholding to stop lending Uncle Sam money interest-free every year. Instead, set aside the $200 or so a month and put this money into an investing plan. That way, you can invest this money as you go along, rather than waiting for Uncle Sam to give it back in the spring.

Any opinions expressed in this column are solely those of the author.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree. He does not own shares in the companies mentioned in this column.