Tax-loss selling, which begins to be a factor in the markets every year around this time, should be particularly pronounced this year.
I’m referring to the practice of selling off losing positions in your portfolio to offset capital gains on which you would otherwise have to pay tax. The reason it should be significant in 2019 is that the stock market was so strong earlier in the year, with the dividend-adjusted S&P 500 index (.SPX) gaining more than 22% through Oct. 25.
Compared with years in which equities were in a bear market or relatively flat, an above-average number of investors today should be sitting on capital gains—and eager to sell some of their losers.
To measure tax-loss selling’s impact, I analyzed a hypothetical portfolio that each month held the 10% of stocks with the worst returns over the trailing year—the ones most likely to be sold for tax-loss selling purposes. I relied on a database that extends back to 1926, maintained by University of Chicago finance professor—and Nobel laureate—Eugene Fama and Dartmouth College professor Ken French.
If tax-loss selling did not play a role, you’d expect this hypothetical portfolio’s returns at the end of the year to be no different than in any other periods. But that’s not what I found. This portfolio’s average monthly returns in the first, second, and third quarters of the year were gains of 1.3%, 0.3%, and 0.2%, respectively. In the last quarter, in contrast, its average monthly return was a loss of 0.5%.
To be sure, end-of-year window dressing is likely also playing a role. That’s the practice pursued by mutual-fund managers of shedding their portfolios of losing stocks before the end of the year, to avoid the embarrassment of including these stocks in year-end reports to investors.
Regardless of the relative roles played by tax-loss selling or end-of-year window dressing, the key to exploiting the phenomena is recognizing that neither factor has anything to do with a stock’s long-term potential. Both are artificial and come to an end on Dec. 31. In the new year, these stocks should bounce back.
Needless to say, it’s important to be choosy and not indiscriminately buy just any stock that has performed dismally. The following list of stocks was compiled by starting with the 10% of stocks in the S&P 1500 index (a total of 150) with the worst year-to-date returns. The list was narrowed down further to include just those that are recommended by one or more of the top-performing investment newsletters I monitor.
The result is 17 stocks, which are listed in alphabetical order:
- BioTelemetry (BEAT)
- Chesapeake Energy (CHK)
- Consolidated Communications Holdings (CNSL)
- Designer Brands (DBI)
- GameStop (GME)
- Gap (GPS)
- Goodyear Tire & Rubber (GT)
- Halliburton (HAL)
- iRobot (IRBT)
- L Brands (LB)
- Macy’s (M)
- McDermott International (MDR)
- Meredith (MDP)
- Meridian Bioscience (VIVO)
- Mosaic (MOS)
- Signet Jewelers (SIG)
- U.S. Silica Holdings (SLCA)
One shrewd trading strategy would be to place buy limit orders—in which trades takes effect only if an asset’s price drops to a certain level—well below the market on a number of stocks such as these. It’s a good bet that tax-loss selling and/or end-of-year window dressing will depress their prices enough to cause at least some of your limits to be hit, enabling you to buy good-quality stocks at fire-sale prices.
If the future is like the past, chances are good your stocks will enjoy a nice bounce in 2020.
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