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Before yesterday's Thanksgiving leftovers even got cold many U.S. consumers ventured out to catch the best Black Friday deals, already worried about how much this holiday shopping season will cost them.
But instead of fretting over how much you'll spend this year, now's the time to focus on how much more you can earn.
You see, over the next few weeks, three year-end trading strategies will come into play, all capable of producing major short-term profits for astute investors.
- Annual tax-loss selling – which, given some major stock and sector declines since early-year highs, could be heavy this year.
- A "Santa Claus rally" in late December, triggered in part by bargain hunters buying beaten down stocks.
- And the "January Effect," a strong tendency for nearly all stocks – especially small caps – to gain during the first month of the year, or even earlier.
We've outlined all three here, so you can pick your favorite option for year-end profiting.
There are a few ways to play the tax-selling phenomena, depending on your goal, but the most common is to offset your taxable gains.
The best time to unload a large paper loss is the end of the year. Taking a loss on a position reduces your trading gains and limits your tax liability. You'll also see professional fund or portfolio managers do it to replace losers with stronger performers before they issue quarterly or annual reports – a process often referred to as "window dressing."
So if you're sitting on a position with a large paper loss in a stock you want to drop, go ahead and sell to realize the losses for tax purposes. But make sure you beat the crowd – begin looking for selling opportunities now, and try to get out on a day when the market – and hopefully your stock – is sharply higher. (No one wants to take a loss that's larger than absolutely necessary, even to save on taxes.)
If you have a handful of losing stocks and don't know where to begin, start with your biggest gainers, or choose those stocks with the poorest fundamentals.
But before you go cleaning house, there are few things to remember to maximize your profit potential from this trading strategy.
Capital losses taken this year can only be used to offset this year's profits, unless your losses exceed gains. Then up to $3,000 in annual losses can be deducted from your ordinary income, or excess losses can be carried forward to offset future years' gains.
Also keep in mind that short-term losses (positions held less than one year) must first be used to offset short-term gains, which are taxed at higher rates, while long-term losses (positions held over a year and taxed at a lower capital-gains rate) must first be applied to long-term gains. However, net short- and long-term losses or gains can subsequently offset one another in determining your final tax liability.
[Note: To be eligible for tax consideration, trades must settle by the final trading day of the year, meaning they must occur this year no later than the market close on Tuesday, Dec. 27, though most traders like to allow a cushion of at least two or three days.]
Santa Claus Rally
Once the tax-loss selling subsides, the market often rebounds strongly into the New Year – the so-called Santa Claus rally.
No one's positive what causes this rally, but the effect has been significant – a 25-year average gain of 5.0% in the Standard & Poor's 500 Index from the end of November to the start of January.
The rally used to start toward the end of December, but as more traders have recognized and begun playing this bullish market trend, the start of the upturn has moved to mid-December – and that's when you should turn bullish as well.
The best buying opportunities will be companies that have suffered some tax selling and are well off earlier highs, but still have good fundamentals or just reported strong recent earnings.
An example is Target Corp. (NYSE: TGT), which could see some modest tax-loss selling since it's off its early-year trading range of $58 to $60. However, it reported strong third-quarter earnings on Nov. 16, reflecting gains it's making on major competitor Wal-Mart Stores Inc. (NYSE: WMT), and those results could accelerate gains in any year-end rally.
Speaking of Wal-Mart, another stock that could see a Santa rally is Murphy Oil Corp. (NYSE: MUR), which runs the gas stations at most Wal-Mart locations. At its recent price of $54.10, it's well below the $70 to $75 trading range it occupied at the beginning of the year, making it ripe for tax selling. But with profits projected to grow sharply this year – $5.93 a share vs. $4.28 a year ago – and oil prices moving back above $100 a barrel this week, it's almost certainly due for a strong rebound in 2012.
If you find companies you think can pop at the end of the year, next week is the time to start buying. Or, if you merely want to speculate on the likely rally, you can play it by purchasing at- or slightly out-of-the-money January call options on either individual stocks or one of the broad indexes.
A third alternative is to purchase shares in one of the leading exchange-traded funds (ETFs) that track the major indexes – say the SPDR S&P 500 ETF (NYSEArca: SPY). These low-cost funds closely mirror the performance of their underlying indexes and will let you ride any broad rally without having to sweat its impact on one or two individual stocks.
Using an ETF would also let you play the January Effect, an extension of December's Santa rally.
The January Effect
The January Effect is the idea that stocks tend to rise at the year's start as investors hunt for positions to replace those they closed in late December for tax purposes.
The effect has been more pronounced on small-capitalization issues than on large- and mid-cap stocks – an advantage of 2.5% from 1927 to 2004, according to one study. Investors holding cash from selling big-cap losers tend to look for emerging opportunities among smaller or newer companies.
The January Effect has become a bit less pronounced in recent years, primarily because more people are aware of it – but it's still worth playing.
Its timeframe has also shifted forward a few weeks, starting in mid-December instead of after the first of the year. Every year Ned Davis Research puts together a January Effect portfolio, generated by screening for the smallest 150 stocks in the Standard & Poor's 1500-stock index that also are among the 10% of stocks furthest from their calendar-year closing high. In 1996 to 2009, the portfolio returned an average 8.6% from mid-December to the end of January, compared to a 3.5% return from Jan. 1 to the end of the month.
Those interested in playing this effect should consider buying shares in the iShares Russell 2000 Index ETF (NYSEArca: IWM), recent price $73.30, which tracks the Russell 2000 Index, a measure of performance by the small-cap segment of U.S. financial markets.
By getting into IWM now, you'll be positioned early to capture any broad market gains that follow a strong Santa Claus rally, and also be poised to profit from any subsequent January Effect surge in small-cap stock prices.
If you want to be more speculative, highly liquid option contracts are available on both the SPY and IWM funds. But beware – this year's market volatility has driven premiums up on all index options, and you could suffer a total loss of your funds should the expected rallies fail to develop or be more modest than in past years.
News and Related Story Links:
- Money Morning:
New York Stock Exchange Holiday Calendar 2011-2013
Might Santa Claus come early this year?
- The Wall Street Journal:
Playing the "January Effect'
- Business Insider:
The 10 Sectors That Got Crushed in Q3