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Tax-Loss Bounce

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My cohort, Jeff Bailey, has been writing about the end-of-year tax-loss bounce. The trade worked very well one year ago, especially in Worldcom (NASDAQ:WCOM). Granted, the Fed surprised the market one year ago with its interest rate cut, which definitely boosted the New Year bounce. But, there may be some more opportunities this year given the continuation of the bear market. Many stocks are down big for the year, which could have exacerbated the tax-loss selling.

The Tax-Loss

Tax-loss selling is when an investor sells a stock in the current year in order to book the loss on his or her taxes. By selling a stock before the close today, an investor can use that loss to offset any gains booked this year. If the investor didn't have any gains to offset, they could use the capital loss as a deduction against income to a maximum of $3,000 per year. If the amount of the loss exceeds $3,000, then the remaining portion can be carried over onto next year's taxes.

An investor may have the incentive to carry the loss over today's close and into next year. That way, the loss can be booked early in '02, where an investor would start the year with a loss on the profit & loss statement. Then, that loss could be used to offset any gains taken throughout '02. So, you'll often see the last year's worst performing stocks sink a bit further at the very beginning of the New Year.

In either case, for tax reasons, investors have an incentive to take a loss against either gains or income. In addition, money managers will often "clean" their portfolios of the year's worst performing positions in an attempt to "hide" the losers from their clients. Look at this way:

Client: "Hey, money manager, why did you hold Global Crossing (NYSE:GX) for the ENTIRE! year for a 95 percent loss?"

Money Manager: "Uhh, I don't know."

In order to escape that question, money managers will dump their worst performing positions. The combination of the window dressing and tax-loss selling can create artificial weakness in a stock near the end of the year. Once the selling is exhausted, a stock can rebound at the beginning of the new year as the supply/demand dynamic reverts back to equilibrium.

We're looking for that situation as we enter a new year and some stocks that may rebound such as the Worldcom trade one year ago.

Comparisons

Worldcom was one of the worst performing big cap stocks during 2000. Indeed, telecom was the first sector to slip into the bear market, eventually dragging others down with it. For 2000, Worldcom was down by about 65 percent. Near the very end of 2000 -- one year ago -- WCOM hit a new 52-week low down around $14, then proceeded to rebound up above the $20 level in early January. Again, the Fed's surprise rate cut added to the bounce. But it was a mighty big bounce, part of which was due to the stock reverting back to a normal supply/demand dynamic.

The Candidates

Looking for this year's (2001) tax-loss bounce candidates, several sector themes were predominant. For instance, the energy sector has a number of stocks down by a significant amount year-to-date. Most stocks that are levered to the telecom industry are down big on the year. Networking equipment stocks were omnipresent on this year's worst performing list. And there were several dot com-related stocks lingering on the list.

The energy sector's worst performing stocks are interesting to me. The energy sector, as measured by the Oil Service Index (OSX), Oil Index (OIX), and Natural Gas Index (XNG), has recently shown signs of life thanks in part to OPEC's proposed production cuts. If the recent positive trend in energy continues, then some of the energy-related candidates may be worth a close look for tax-loss bounce trades.

Here's a list of some of the stocks I found that could trade higher in the early part of the new year on the tax-loss bounce thesis. The list is by no means a recommendation to buy any of these stocks. Many of these companies appear to be in trouble and some may not make it through next year. You'll notice that most are trading very near their yearly or all-time lows. But so was Worldcom one year ago. Again, these are candidates for a bounce in the next several weeks; they are trades, not long-term positions. Here's the list in no particular order:

TXCC INKT NTG TORC TMR MSSN ATPG
FIRE CORV AETH ADCT NEWP AKAM

Jeff Bailey and I will be following the progress of some of these stocks over the next few weeks. If you've found some candidates that could bounce in the next few weeks, feel free to send them along and I'll take a closer look:

Contact Support

Eric Utley
Option Investor

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