The January Bounce-Back: Profiting from Underperforming Stocks
Explore why underperforming stocks have a tendency to rebound in January and learn a strategy to profit from this pattern. Discover the effects of end-of-year window dressing and tax-loss selling on these stocks.
Troy D. Hanson
October 25, 2023
It may seem tempting to offload the stocks that have fared poorly this year, but as we delve into the market's dynamics, a different perspective emerges. Surprisingly, these underperforming stocks are more likely to turn the tables and emerge as the best performers in January.
What causes this unexpected reversal? Well, it's a combination of two artificial factors that exert selling pressure on these stocks, unrelated to their fundamental value or potential earnings. Importantly, these pressure points cease to exist on December 31st, leading to a significant resurgence of these stocks in January.
The first factor is known as "end-of-year window dressing." This practice involves portfolio managers selling their portfolio's laggards to avoid showcasing them in their year-end reports. The second factor is "tax-loss selling," where investors sell certain stocks that have incurred losses to offset their capital gains taxes for the year 2024.
To observe this pattern of January bounce-back, let's take a look at the chart below. It presents data since 1927, courtesy of Dartmouth College's Ken French. The chart depicts the returns of a hypothetical portfolio that every month invests in the 10% of stocks with the poorest trailing-year performance. Notably, January exhibits the strongest average returns, while the end of the year experiences the lowest returns.
In summary, it's wise not to hastily discard underperforming stocks. With the culmination of end-of-year window dressing and tax-loss selling on December 31st, these stocks are poised for an impressive rebound come January.
Exploiting the Pattern for Potential Gains
If you're looking to take advantage of a specific investment pattern, there's a strategy worth considering. Start by reviewing a list of the biggest losers in terms of year-to-date performance. From this list, identify a few stocks that catch your interest and place buy orders for them at significantly lower prices than their current trading value. If luck is on your side, the effects of year-end window dressing and tax-loss selling may lead to a decrease in prices, allowing some of your orders to be filled. This means that when January comes around, there's a good chance you could reap substantial gains.
Illustrating the effectiveness of this approach, let's look back at the example from last year. I selected the 10% worst performers among the S&P 1500 stocks in terms of year-to-date performance. From this initial list, I further narrowed it down to include only those that were recommended by any of the investment newsletters our firm monitors. The final result consisted of 20 stocks. In January of that year, these stocks delivered an average gain of 21.8%, far surpassing the S&P 500's 6.3% increase.
Taking a similar approach, I have compiled below this year's list of worst year-to-date performers in the S&P 1500 so far. Each of the stocks listed has received a recommendation from at least one of the investment newsletters we monitor.
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