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To find a prince, you sometimes have to kiss a lot of toads—especially as we approach the end of the year.
One of the more successful trading strategies of the entire calendar involves buying the worst year-to-date performers in December, in anticipation of a rebound in January.
This year-end strategy is made possible courtesy of the Internal Revenue Service, which allows investors to avoid paying some or all of the capital-gains taxes they otherwise would owe if they have capital losses to offset their gains.
To realize their losses, however, investors must sell their losers before Dec. 31, and that causes stocks that are already down on their luck to fall even further. Once that tax-induced selling pressure is removed in the new year, such stocks bounce back more often than not.
George Putnam, editor of the Turnaround Letter, has been putting this theory into practice for years. He is one of the select few advisors I follow who has beaten the stock market on a real-world basis over the long term. I calculate that his model portfolios, on average, have delivered an annual return of 11.9%—versus the Standard & Poor’s 500 index’s 10.6%—since the late 1980s, including dividends.
Consider the seven stocks that Putnam recommended last December as year-end bounce candidates. From the date of his recommendation in early December to the end of January, they produced an average gain of 8.0%, versus 3.0% for the S&P 500.
In an interview, Putnam told me that there’s a good chance that this year-end strategy will be especially profitable this coming December and January. “The stock market’s performance this year has been quite strong, and many investors are therefore likely to be sitting on healthy capital gains that they will want to offset with losses,” he notes.
Might the tax-reform legislation currently racing through Congress affect this year-end strategy? John Petosa, a professor of accounting at Syracuse University’s Martin J. Whitman School of Management, doesn’t think so. In an interview, he told me that he has seen nothing in what has been proposed so far “that would deter an investor from pursuing a strategy of taking losses in order to shield gains.”
To be sure, he adds, the “devil is in the details,” and the Republicans’ tax plan will undoubtedly undergo many changes as it makes its way through the legislative process in coming weeks. But there has been no indication that the GOP wants to change the tax treatment of capital gains. And even if it does, those changes almost certainly would not take effect before 2018, which would leave in place all the tax-related incentives to realize losses in December of this year.
Putnam has not yet come up with a new list of year-end rebound candidates. But he told me that he focuses on those stocks with the biggest year-to-date losses, and sometimes those with two-year losses. He also wants to make sure that the stocks are of companies with “reasonably sound” businesses—“not headed for bankruptcy,” in other words.
You might think this strategy works best with the smallest-cap stocks, since their trading volume is relatively light and their prices particularly sensitive to tax-loss selling. But Putnam said that the year-end bounce strategy also can work with larger-cap stocks as well. That’s because these stocks face artificial selling pressure for an additional reason besides tax-loss selling: Window dressing by mutual funds that don’t want their year-end reports to show that they owned a losing stock. Such selling pressure is lifted once the calendar shifts to January, needless to say.
One large-cap stock that Putnam mentioned specifically in this regard is General Electric (ticker: GE), that erstwhile bluest of blue chips whose stock is down 30% so far this year. But he thinks that investors don’t appreciate the stock’s long-term potential. “The recent drama is the natural byproduct of the speed and boldness of a new CEO who is determined to toss overboard a failed strategy and improve GE’s operating performance, which should ultimately boost its share performance,” he argues.
The table below contains 10 stocks within the S&P 500 with the biggest year-to-date losses that are also below their two-year-ago level, yet nevertheless pay a dividend and sport a price/earnings ratio (based on 12-month estimated earnings) and a price/book ratio below that of the overall market.
10 Losers Worth Betting On
Year To Date
|Trailing 24 Months||Price/Earnings Ratio*||Price/Book Ratio||Dividend Yield|
|AAP||Advance Auto Parts||-49.3%||-55.3%||16.6||1.9||+0.3%|
|ALK||Alaska Air Group||-25.5%||-15.0%||9.5||2.2||+1.8%|
|Standard & Poor’s 500||14.4%||23.6%||19.6||3.2||+2.0%|
Note: Returns as of 10/27/2017
* Based on estimates of forward 12-month earnings.
One approach to these or similar stocks is to place buy-limit orders well below their current prices. If tax-loss selling and window dressing depress them enough, you will be buying them at artificially depressed prices. Then, assuming the future is like the past, these stocks will rebound in 2018 as that artificial selling abates.
Two qualifications are in order. One is that pursuing this strategy requires a degree of contrarian courage that many investors do not possess. It’s a lot easier to invest in a winner than a loser, after all. But, to repeat the infamous advice from the Baron Nathan Rothschild, “The time to buy is when there’s blood in the streets.”
The second qualification comes from Putnam: The year-end bounce-back strategy won’t work, at least not right away, if the stock market plunges at the beginning of the year. The stock market did just that in January 2016, you may recall, and Putnam’s year-end bounce candidates from December 2015 didn’t show an average profit until the end of March 2016.