A Once-a-Year Investing Opportunity; Many stocks are artificially depressed by year-end tax-loss selling

A Once-a-Year Investing Opportunity

Many stocks are artificially depressed by year-end tax-loss selling.

MARK HULBERT

Nov. 1, 2013 6:52 p.m. ET

One of the year’s best trading opportunities is about to come around. Some even refer to it as a “free lunch.” The strategy involves buying stocks in the last few weeks of the year that are artificially depressed after investors sell them off for tax reasons. Often, these stocks bounce back nicely in January after this selling has abated. You should begin now to prepare the list of stocks you would want to buy should “tax-loss selling,” as it is called, depress their prices. Such selling has begun as early as November in recent years, and some traders have immediately snatched up the resultant bargains. You could miss out on some great deals if you wait until late December to act.The tax code is the ultimate source of this year-end trading opportunity. If an investor sells a stock he is holding at a loss, he can use that loss to offset other gains he already has realized from selling winners earlier in the year on which he would otherwise owe capital-gains taxes.

Since those taxes are substantial—as high as 43.4% at the federal level for gains on investments held less than a year, plus whatever additional capital-gains tax is levied at the state level—it can make sense to sell a stock to book a loss even when its longer-term prospects are very attractive.

Which stocks are most likely to be affected by tax-loss selling? George Putnam, editor of the Turnaround Letter advisory service, says a good place to start is those with the biggest year-to-date losses.

Over the past 15 years, according to the Hulbert Financial Digest, Mr. Putnam’s model portfolios have produced an average annualized return of 13.8%, more than doubling the 6.1% for the Wilshire 5000, which represents the combined value of all publicly traded stocks, assuming dividends are reinvested.

Mr. Putnam is a contrarian, searching for out-of-favor stocks that he believes will eventually recover. He says that he almost always focuses on stocks that he will buy and hold for the long term, but he makes an exception for the short-term year-end tax-loss strategy.

Take Hewlett-Packard, HPQ +6.36% a widely held stock that was the worst performer in 2012 of any of the 30 Dow DOW -1.32% Jones Industrial stocks. At its mid-November low a year ago, the stock was posting a year-to-date loss of more than 50%. From then to the end of this last January—a period of just over two months—the stock gained 47%.

Hewlett-Packard’s impressive rebound wasn’t a fluke. It was one of 10 stocks that Mr. Putnam had recommended at the end of last November for a year-end bounce.

Those stocks’ average gain from then until the end of this past January was 19.2%, according to FactSet, more than triple the 5.8% gain of the S&P 500 over the same period.

The performance of this year-end bounce strategy isn’t always that impressive. It tends to be strongest in years like 2012 when the major market averages have posted the biggest gains going into the last couple of months of the year, since in those years investors will have the greatest amount of gains that they want to offset.

When the market is posting a year-to-date loss going into the end-of-year period, by contrast, investors will have fewer gains that need to be offset by selling losers.

Take 2008, the heart of the 2007-09 bear market. The list of year-end-bounce candidates Mr. Putnam compiled at the end of November 2008 lost an average of 2.1% from then until the end of the subsequent January, according to FactSet. Still, they outperformed the S&P 500, which lost 7.9% over the same period.

Given the stock market’s impressive strength this year, we should see a lot of tax-loss selling over the next two months. Both the S&P 500 and the Dow have been breaking record after record, and the entire stock market—as measured by the Wilshire 5000—is sporting a year-to-date gain of 26%. That means there should be plenty of stocks that will bounce back in January.

In preparing a list of stocks that you would want to buy, assuming tax-loss selling depresses their prices, you should exclude stocks whose prospects are “hopeless,” according to Mr. Putnam. One way to do that is to include only those that also are recommended by advisers with good long-term records.

The following stocks are those in the S&P 1500 index that have lost at least 20% this year and which currently are recommended by one or more of the Hulbert Financial Digest-monitored advisers who have beaten the market over the past 15 years.

They are clothing retailer American Eagle Outfitters AEO -2.32% ; Higher One Holdings,ONE +0.50% a financial-aid processing company; Intuitive Surgical, ISRG +0.14% which manufactures surgical equipment; Liquidity Services, LQDT +1.88% which operates online auctions for selling surplus equipment; home builder M.D.C. Holdings MDC -1.37% ; gold miner Newmont Mining NEM -4.70% ; Procera Networks, PKT -3.04% a wireless-network component manufacturer; Teradata, TDC -0.16% which provides data warehousing; andTitan International, TWI +0.07% which makes wheels and tires for off-highway vehicles.

Note that you shouldn’t immediately buy these or other stocks that are sporting big year-to-date losses. Instead, you should wait until tax-loss selling depresses their prices even more in coming weeks.

One helpful rule of thumb might be to buy only those stocks whose price drops 5% or more from current levels. Not all of the stocks on your watch list will fall that much, but—if past experience is any guide—a number of them will.