Opinion: What will be the best-performing stocks in January can be bought today because of these two crosscurrents in the market

Tax-loss selling occurs when investors sell losing positions to offset capital gains on which they would otherwise have to pay tax. End-of-year window dressing occurs when mutual funds sell their losing stocks before Dec. 31 to avoid the embarrassment of including these stocks in year-end reports to investors. Notice that both have the same consequence of concentrating end-of-year selling in stocks that are already the worst performers over the trailing year.

Notice also that selling because of either of these factors is artificial, in the sense that it has nothing to do with the stocks’ underlying fundamentals. This is why, come January and the end-of-year artificial selling pressure has dissipated, the stocks that suffered the most in November and December are among January’s best performers.

The accompanying chart summarizes this end-of-year pattern. The chart reports the average monthly performance since 1927 of the 10% of stocks with the worst trailing-year returns. In the fourth quarter of the year, this decile loses an average of 0.35% per month. That’s significantly worse than the overall market’s average monthly gain of 1.24% during the fourth quarter. (These data are courtesy of Dartmouth professor Ken French.)

In January, in contrast, the trailing year’s worst performers gain a stunning 3.61%, on average — in contrast to the overall market’s average gain of 1.41% in January. In other words, the trailing year’s worst-performing decile goes from having a negative monthly alpha of 1.59 percentage points in the fourth quarter of the year to a positive alpha in January of 2.20 percentage points.

Strong as this historical pattern is, however, it doesn’t work with each and every stock that is down on its luck as the year’s end approaches. It therefore is important to be choosy.

The following list of loser stocks was compiled by starting with the 10% of stocks in the S&P 1500 index with the worst year-to-date returns. (The S&P 1500 includes the S&P 500
SPX
as well as mid-cap and small-cap indexes.) The list was narrowed further to include just those that are recommended by one or more of the top-performing investment newsletters I monitor.

I once before proposed this approach, in a column three years ago for Barron’s. The 17 stocks listed in that column proceeded to perform as expected: From their lowest prices in the last two months of 2019 to their highest prices in January 2020, the stocks produced an average gain of 44.1% — in contrast to 10.3% for the S&P 500.

Though this 44.1% gain is hypothetical, since you’d have to have perfect foresight to know when a stock would hit its lowest or highest price, it illustrates the bounce-back potential, which is more than four times higher than for the market as a whole.

More stocks satisfied my criteria this year than three years ago, so I further narrowed the list to include those with the smallest market capitalizations. That’s because tax-loss selling and end-of-year window dressing have their greatest impacts on the smallest stocks.

As a cutoff, I used the market cap of the largest stock in the S&P Midcap 400 index. The stocks that survived my winnowing process are listed below in order of their year-to-date losses (per FactSet calculations).

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].