Investors who have suffered major losses this year, such as during the October sell-off, may be engaged in tax loss selling, also called tax loss harvesting, through the rest of 2018. “In a year characterized by volatility and reversals, the next catalyst may be tax loss harvesting,” according to Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch, in a recent note to clients as quoted by CNBC. Research by BAML stretching back to 1986 indicates that certain beaten-down stocks ripe for tax loss harvesting enjoyed an average gain of 5.1% during the three months after the Oct. 31 deadline, better than the 3.7% average gain for the S&P 500 Index (SPX) as a whole.
These 6 large-cap stocks are what Subramanian calls tax loss candidates, or TLCs, that are likely to rebound based on BAML’s analysis: AT&T Inc. (T), BlackRock Inc. (BLK), 3M Co. (MMM), Facebook Inc. (FB), Wells Fargo & Co. (WFC), and Goldman Sachs Group Inc. (GS). BAML screened for S&P 500 stocks that were down by at least 10% for the year-to-date (YTD) through Oct. 31, but still had “buy” ratings from their analysts. The table below shows the recent YTD price declines for these stocks.
6 Stocks Ripe for Short-Term Gains
|Stock||YTD 10/31 Decline||YTD 11/16 Decline|
Source: Yahoo Finance for adjusted closing price data
Significance for Investors
While individual investors have until December 31 to harvest their tax losses for 2018, mutual funds faced a deadline on Oct. 31. Tax loss selling involves generating realized losses on losing stocks to offset realized gains on the winners, and thus reducing net capital gains, and the associated capital gains tax liability, reported for 2018. This wave of selling normally puts additional downward pressure on the prices of these stocks. However, BAML’s analysis suggests that the further price declines induced by tax harvesting might induce subsequent heavy buying by bargain hunters.
From 2000 through 2012, tax loss candidates, or TLCs, outperformed the market in every year except 2007 for the period from November through January. They also outperformed in 2016 and 2017. Underperformance of the strategy in 2013 through 2015 is attributed by BAML to the influence of macro events late in those years, such as a U.S. federal government shutdown, moves by OPEC regarding oil prices, and Federal Reserve policy announcements. While this represents a 78% success rate in the last 18 years, BAML indicates that, since 1986, it has a 69% hit rate.
“In a year characterized by volatility and reversals, the next catalyst may be tax loss harvesting.” —Savita Subramanian, head of U.S. equity and quantitative strategy, Bank of America Merrill Lynch
Subramanian notes that the TLC trading strategy has produced its highest median monthly returns in November and January, the months which follow the tax harvesting deadlines of Oct. 31 for mutual funds and Dec. 31 for most other investors. However, it tends to lag the S&P 500 in the month of December, which is “seasonally strong” on average, she adds.
In October, Morgan Stanley produced a list of 118 stocks that, according to its own screening methodology, were prime candidates for heavy tax loss selling, as detailed in another Investopedia article. However, while BAML looked for such stocks that might rebound, Morgan Stanley’s screens were aimed at finding stocks that are likely to suffer further underperformance. Among these were BlackRock, The Kraft Heinz Co. (KHC), Goodyear Tire & Rubber Co. (GT), Halliburton Co. (HAL), MGM Resorts International (MGM) and Nutrisystem Inc. (NTRI).
Morgan Stanley based its analysis on prices as of Sept. 28. From that date through Nov. 16, Nutrisystem is up fractionally, Goodyear is down by 4%, Kraft Heinz and MGM Resorts down by 5%, BlackRock down by 13%, and Halliburton down by 20%. The S&P 500 is down by 6% over the same period.
As the narrative above indicates, expert opinion can be split on the future direction of tax loss selling candidates, with Morgan Stanley seeing further underperformance ahead for BlackRock, while BAML judges it to be poised for a rebound. Also, as the table shows, only 3M seems to be in the midst of such a rebound so far, while Facebook and Goldman have suffered significant further declines. It is much too early to say that this invalidates the BAML model, but it nonetheless is an inauspicious start.
Finally, as was the case in the period from 2013 to 2015, macro forces ultimately will play a large role in determining the direction of these stocks. This year, trade conflicts, worries about decelerating economic growth, inflation, and rising interest rates are all key matters for concern.