The Dow Jones Industrial Average gained a thousand points in a month. In just the first three days of 2018, all three U.S. averages hit consecutive record highs. Overseas indexes did even better.

 

Japan, for example, was up more than 3 percent on its first trading day of the year. Emerging markets continue to make new highs, while European bourses continue to climb. Those who expected the markets to tank in the New Year have thus far been wrong. How long can this last?

 

Short sellers, convinced that stocks just have to come down, bet on a market decline and have had their head handed to them on a daily basis. Undeterred, they point to the "overbought" indicators that have been flashing red for weeks now. Investor sentiment numbers continue to climb to nose-bleed levels as well, which is usually a contrary indicator. Still, the markets climb higher.

 

There is an old saying among traders that "the markets can remain irrational, longer than you can remain solvent." It is something that all investors should not forget. We are experiencing a melt-up and if one is on the bull train, remain on it. If, on the other hand, you still have that yearly cash bonus, practice a little patience. There will come a time when you can put that new money to work, just not quite yet.

 

We are in a period of goldilocks-type conditions that one rarely sees in the stock market. We have low, even historically low, interest rates given the growth rate of the global economy. Negative interest rates in a large part of the world are coupled with accelerating growth. At the same time, the U.S. economy, which has been growing moderately, may now get a new burst of energy thanks to the newly-passed tax reform. If our Twitterer-in- Chief is correct, the $1.5 trillion in tax cuts for one and all will create a robust environment for additional consumer spending as well as capital investment.

 

The U.S. could therefore act as a speeding locomotive pulling the rest of the world's economies along at an ever-increasing rate. It is similar to what happened back in the early 2000s when China's economy exploded. Almost every nation on earth benefited from that economic miracle. Some think this could happen again, only this time to the U.S., under the Trump presidency.

 

Maybe a simpler answer for today's market gains lies in the fact that we are entering a new stage of the market's emotional cycle. We call it the optimistic stage, where prices rise as new capital is put to work by current market players, as well as by new market participants, who have been on the sidelines.

 

It is difficult to predict the length of this phase (if it has truly begun) because it is dependent upon the success of that invested capital, as well as the time required to generate a positive rate of return for this risk capital.

 

One highly-respected, gray-haired sage of stock markets I respect is Jeremy Grantham, founder and chief Investment officer of Boston-based Grantham Mayo Van Otterloo. In his company's latest investment letter, Grantham believes we are currently showing signs of entering the blow-off or melt-up phase of this bull market.

 

"I recognize on one hand that this is one of the highest-priced markets in U.S. history, he writes. "On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market."

 

He adds that the end of this phase could take anywhere from another six months to two years to complete before all is said and done. Before we do, we should expect the final emotional stage of the market to unfold. That is when euphoria takes over and stock prices reach their zenith. Parabolic price gains become the norm and a false feeling of well-being occupies the investor psyche. But don't worry, I see no signs of this occurring as of yet. So enjoy your gains and expect more in the future.

 

Plenty of investors will be faced with an unpleasant surprise. Any day now, one or more of the mutual funds that you own will be sending out their capital gain distributions for the year.

 

The tax hit could be quite large this year.

 

Many investors are not aware that mutual fund companies are required to distribute at least 95 percent of their capital gains to investors each year. Given the double-digit gains in the stock market last year, those gains could be an unwelcome liability when tax time rolls around.

 

At this late date, there is little one can do about it, other than pay the piper, but this year you can take steps to minimize 2018's potential tax liability. Since the tax reform act did not change capital gains taxes, you can expect that short-term capital gains (less than 12 months) will be taxed at the same rate as your income tax bracket. Long-term capital gains, however, will continue to be taxed at 15 percent.

 

The job of most mutual fund managers is to buy low and sell high. That's what creates track records, which, in turn, attracts investors to their funds. But mutual funds are just like individuals when it comes to capital gains. Anytime a mutual fund sells a security, no matter what the asset, that gain is taxable. And since mutual funds are considered pass-through entities, they are required to pass along to you any of these taxable gains.

 

In the grand scheme of things, capital gains distributions could be considered a luxury problem since we want the mutual fund we are invested in to turn a profit for us. So producing capital gains (as opposed to capital losses) is a good thing. But some caveats do apply.

 

Distributions reduce the fund's net asset value, regardless of whether they are long-term, or short-term capital gains, qualified dividends, or a return of capital. The problem might be in the timing of your purchase. If, for example, you purchased such a fund after all the gains were made, but before the distribution, you will be sent the capital gain (plus the taxes you will owe) while the mutual fund you purchased would decline by the amount of the distribution. You would be left with an after-tax loss on that mutual fund investment.

 

So the morale of this tale is if you are going to stay invested in mutual funds in a non-retirement account you better start tracking the upcoming capital gains distributions on the funds you own or are considering purchasing. In general, most mutual funds pay one or two capital gain distributions each year, normally sometime during the summer, and the last one toward the end of the year (late November or December). Try to avoid buying mutual funds at those times.

 

The mutual fund industry is aware of how these sudden taxable events impact shareholders. Most managers try to avoid dumping huge gains on investors, especially short-term gains, which are taxed at a higher rate. However, at certain times, they are forced to do just that.

 

During market declines, for example, when they are faced with unusually large redemption requests, then fund managers may be forced to liquidate positions that they would have preferred to hold, but can't.

 

Today a shareholder of mutual funds can easily find out when and what upcoming distributions will be made by simply accessing each mutual fund's website. There, you will find a wealth of information concerning distributions. Many fund websites will give you distribution guidance several months before the event. That makes it easier for you to make informed investment decisions.

 

Bill Schmick is registered as an investment adviser representative and portfolio manager with Berkshire Money Management (BMM), managing over $200 million for investors in the Berkshires.  Bill's forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquiries to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.