The post-election sell-off in the market has acutely reminded everyone of the impending Fiscal that Cliff the US faces in less than 2 short months.
This is when tax rates are scheduled to go up while spending cuts are slated to kick in.
It's a one-two punch that could have a devastating effect on the US economy and world markets. And it's why other world bodies, such as the G-20 and the IMF, are urging the US to resolve the issue as soon as possible, given how fragile the global economy is at the moment.
The good news is that many believe some sort of compromise will be made. Many of the tax cuts for the overwhelming majority of Americans are likely to stay, while the massive, across the board spending cuts will likely be redefined as more thoughtful cuts, spread out over a longer period of time.
But, a compromise only serves to make the Fiscal Cliff smaller. It does not erase it. So there will be some short-term pain. But if it's done in a way that can reduce the deficit while at the same time not derailing growth in any meaningful way (or better yet, promote it) the markets should be fine.
So Why is the Market Coming Under Such Pressure?
I believe it's because tax rates on investments appear likely to go up.
The tax rates on long-term capital gains, which now stands at 15%, is likely to go up to 20% (21.2% if you add in the new taxes that will be levied due to the Affordable Healthcare Act) and possibly as high as 25% (when an additional 3.8% tax, also part of the new health care law, goes into effect for the highest income earners).
Short-term capital gains, as well as taxes on dividends, might go up as well.
That's why there is an incentive to lock in gains now before rates go up.
For example, if someone amassed $100,000 in long-term capital gains, he would have to pay $15,000 in taxes. However, if he waited, and hoped for the best, he could then, conceivably, have to pay $25,000 on that same $100,000.
Now let's say you have tens of tens of millions of dollars of gains, or more. You could sell now and pay only 15% on those gains, or wait and sell later, and potentially pay 66% more in taxes.
Nobody knows for sure if this will happen. But, this is why many top advisors are telling their wealthiest customers to lock in their gains now to take advantage of what could be the lowest capital gains tax rates they'll see for the rest of their life.
I believe this is all short-term in nature however. Because if a deal is made on the Fiscal Cliff, higher investment taxes notwithstanding, the economy will stay the course and the market should ultimately go back up, which means all of that money should find its way back into the market, as the US will still be considered the best game in town.
But for now, I believe the market will come under pressure throughout the rest of the year as investors race to benefit from the low tax rates that might soon expire and go up.
Stock Picking Strategy to Beat the Tax Induced Sell-Off
So where will some of that money go (it's unlikely to just sit in 'cash') and where should new investment dollars go while this tax strategy induced selling runs its course?
I laid out one strategy in a post-election webinar we did last week. And I've been asked to flesh this out a bit more. So here it is.
I believe the stocks with the largest gains over the last 1-3 years are prime candidates to see the greatest amount of tax related selling.
On the flip-side, the ones with smaller gains to lock in should see the least amount of tax induced selling.
Of course, that doesn't mean you should buy the crummiest stocks out there. You still want to make sure the odds are in your favor for future gains.
My strategy right now is as follows:
Focus in on the Top 50% of Industries
Specifically, focus in on the top 50% of Zacks Ranked Industries. For one, the top 50% of industries has been show to beat the bottom 50% of industries by a factor of more than 2 to 1. This one item alone helps put the odds in your favor of getting into a promising stock.
Select Stocks with a Favorable Zacks Rank
This screen selects Zacks #1 Rank and Zacks #2 Rank stocks, which are Strong Buys and Buys, respectively. You can choose to include some Zacks #3 Rank stocks or Holds if you'd like. But with the Zacks #1 Rank stocks showing over a 25% average annual return of over the last 26 years and the #2's doing over 18%, this is item that can further tilt the stock picking odds in your favor. And by focusing in on the best Zacks Ranked stocks, you can be sure those are the ones receiving the best upward earnings estimate revisions.
Pick Stocks that have Underperformed the Market This Year
The item I'm using to determine underperformance is the Relative % Price Change vs. the S&P 500 over the last 52 Weeks. But I'm also making sure that they were up for the year so there's no incentive for tax loss selling either. For that, I'm using the simple % Price Change over the last 52 Weeks. As mentioned earlier, stocks that outperformed and have racked up big gains are likely to come under the most tax related selling pressure. Those with smaller gains should suffer the least amount of selling pressure, since there's a smaller tax advantage to benefit from.
This strategy will produce approximately 50 stocks at a time.
Once you generate this list, be sure to apply your favorite, proven valuation metrics to further narrow down your selection to find those with the best value.
After the first of the year, and as soon as we get a bit of clarity of what the Fiscal Cliff will look like, my focus will then be on those stocks that were the best outperformers over the last 1-3 years, but that suffered the biggest declines over the last few months. As long as those stocks still have their fundamental and technical stories intact, those will likely be the stocks that will see the most amount of investor interest as they'll be able to pick up their favorite stocks at a meaningful discount.
But that's for another time and another article.
For now, take a look at the underperformers, but with the best short-term outlooks, as a place to stash your money until the strategy of tax selling is over.
5 Stocks to Beat the Tax Selling Trap
Here are 5 highlighted stocks from this weeks screen:
( They are in the Finance - Investment Management Industry. They are ranked 42 out of 265 industries, placing it in the top 16% of Zacks Ranked Industries. They have a Zacks #2 Rank (Buy). There's little incentive to sell for tax purposes considering their 1.04% gain over the last 52 weeks. But this company's services should be highly sought as the tax landscape changes for both investments and business. BX - Analyst Report) Blackstone Group
( This Residential REIT has a Zacks #2 Rank (Buy), while its industry is ranked 52 out of 265 for a spot in the top 20% of Zacks Ranked Industries. With only a 7.8% gain over the last 52 weeks, it's unlikely to experience much end-of-year tax selling. But with the entire housing market expected to continue its recovery in 2013, CPT should benefit nicely going forward. CPT - Snapshot Report) Camden Property Trust
( This stock is also in the Finance industry, but categorized under Misc. Services. They are ranked 32 out of 265, putting it in the top 12% of Zacks Ranked Industries. They're up 8.4% over the last 52 weeks, but have been confined to a relatively narrow trading band for the last 3 years. However, they currently sport a Zacks #1 Rank (Strong Buy) in an industry that keeps growing (they provide secure electronic transaction solutions). An upside breakout could be just around the corner. EEFT - Snapshot Report) Euronet Worldwide
( They are one of the most widely known and trusted food products companies in the world. They have a Zacks #2 Rank (Buy) in an industry ranked in the top 10% of Zacks Ranked Industries (25 out of 265). They had a solid year in 2010, but have pretty much traded sideways for the last two years and have essentially been flat for the last 52 weeks with a 0.07% gain. There's little reason to sell for tax reasons if you got in over the last couple of years. But with a big base building near its 52-week high, this one looks set to breakout to new highs, as stocks trading near their highs have a tendency of doing. HRL - Analyst Report) Hormel Foods
( They are in the Staffing Industry within the larger Business Services Sector. They are ranked in the top 41% of Zacks Ranked Industries (108 out of 265), making the cut for the top 50% of industries with room to spare. Employment has been a drag on the economy. This is likely why RECN has only been able to show a 3.14% gain over the last 52 weeks. But the jobs market is slowly getting better. And with RECN's Zacks #2 Rank (Buy), and solid double-digit projected growth rates, so should their fortunes. RECN - Snapshot Report) Resources Connection
Get the rest of the stocks on this list, and start fortifying your portfolio as the end of the year tax selling pressure picks up steam, and the theatrics surrounding the Fiscal Cliff fight heats up.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks portfolios and strategies are available at: http://www.zacks.com/performance.