Slim Pickings in Tax-Bounce Plays

 | Nov 19, 2013 | 2:00 PM EST
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One relatively tried and true market strategy has been to play the year-end tax bounce. This entails screening for the year's biggest losers and building a basket of so-called tax-bounce candidates. 

The rationale behind this strategy is to take advantage of tax-driven selling, as mutual funds and individual investors sell their biggest losers before the year closes out in order to reduce annual realized gains. Of course, this tax-selling gambit puts seasonal pressure on the year's biggest dogs, producing even greater declines than should be warranted by their fundamentals, as tax-driven sellers are more highly motivated than buyers at year-end. 

After the year-end tax selling pressure abates (the tax years of most mutual funds end on Oct. 31, while for individuals the end of the tax year is Dec. 31), the universe of losing stocks should fared better in the first few weeks of the new year, and historically has done so, as these stocks benefit from a catch-up bounce. 

Normally, the best way to play the bounce has been to screen the year's losers in order to build a "tax-bounce portfolio."

At first glance, we once again would have expected this strategy to be interesting and opportunistic in 2013. After all, this is a year in which the tax rate on capital gains has risen, and of course the market has had robust gains. Therefore, investors probably have more than usual realized capital gains, which also means the universe of losers would likely be more limited. In theory, this should put the losers under more than usual selling pressure as more investors would need greater losses, which would be provided by fewer losers.

So, while on paper 2013 should be a good tax bounce season, the reality is that our screening efforts are generating slim pickings and an unexciting candidate list. In fact, we would venture to say the resulting candidate list was among the least compelling in the more than 20 years that we have been doing this exercise.

We reviewed two groups to build our tax-bounce-candidate universe. In the first, we looked for the worst-performing S&P 500 stocks; in the second we expanded our search to all U.S. stocks with market capitalization of more than $2 billion.  

What we discovered was that, within the S&P 500, there were not a lot of big losers. For many of the losers we didi find, there were some meaningful business risks, which would reduce any interest in owning them. For example, if J.C. Penney (JCP) can turn itself around, its stock is due for a big bounce. However, we don't have the fundamental conviction required to make that bet.

The losers we identified were generally in the in the following sectors:  gold, materials, specialty retail, and other groups that have been negatively impacted by rising interest rates. As each of these areas faces meaningful issues in the upcoming months, we are wary of recommending buying them, even for a relatively short-term hold.

Extending to the second group, homebuilders might provide some opportunity, as they might be under some additional year-end selling pressure.

For those who are inclined to try to play the year-end tax bounce, we would suggest considering the following stocks: Newmont Mining (NEM), Teradata (TDC), Abercrombie and Fitch (ANF), Caterpillar (CAT), Lennar (LEN), D.R. Horton (DHI).

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