Tax-loss harvesting hurt stocks in October. But traders can use this to their advantage.

By Joseph Adinolfi

Tax-advantaged selling heaped more pressure on U.S. stocks last week, according to data from Bank of America. But it could also create opportunities for investors willing to be a little patient.

Traders willing to wait a few months may be able to profit from a reliable historical pattern: stocks that are worst affected by tax-loss harvesting -- when investors dump losing stocks with the intention of reducing their tax obligations -- often see a market-beating rebound in January, according to data from a team of strategists at Bank of America.

Data from BofA's sales desk suggests that tax-related selling by the bank's institutional clients, mostly mutual funds, is likely peaking again this month, as it often does in October, as mutual funds that face an earlier tax deadline (Oct. 31 as opposed to Dec. 31 for private investors) try to make red ink work to their advantage.

Although tax-related selling usually hurts stocks heading into the end of the year, it can also set the stage for a powerful rebound, according to historical data marshaled by Bank of America and others, as traders buy back in following the new year. Tax law requires investors looking for tax advantages to observe a brief waiting period before buying back the stock if they want to write off their losses.

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BofA identifies so-called "tax loss candidates" based on relatively simple criteria: they're typically high-quality stocks -- i.e. those with a "buy" rating from BofA analysts -- that are down 10% or more between Jan. 1 and Oct. 31.

The table below measures historical performance of these companies compared with the S&P 500. What the team found appears pretty compelling: On average, this group beats the large-cap index by 1.9 percentage points between the beginning of November and end of January.

"Since 1986, stocks down 10% or more from Jan. 1-Oct. 31...beat the S&P by 1.9ppt on avg. over the next 3mos. with a 70% hit rate," a team led by Savita Subramanian, BofA's top quantitative strategist, said in a note to clients shared with MarketWatch on Monday.

There's no shortage of candidates this year, given that many stocks are sitting on sizable losses year-to-date despite the advance in the S&P 500 and Nasdaq Composite. Gains for these indexes have been largely driven by a handful of megacap technology companies, as MarketWatch has previously reported, while the vast majority of S&P 500 stocks are sitting on losses year-to-date.

Here's a list from BofA of potential opportunities for intrepid traders that includes five Dow components: Coca Cola Co. (KO), Home Depot Inc. (HD), Goldman Sachs Group (GS), Citigroup Inc. (C) and Honeywell International (HON).

By comparison, the S&P 500 SPX is up 7.9% year-to-date as of Monday morning trade, while the Nasdaq Composite COMP is up 21.6%, according to FactSet data.

The Dow Jones Industrial Average DJIA, meanwhile, is sitting on a loss of 1.4%, while the S&P 500 equal-weighted index RSP, which treats every component stock equally instead of slanting the index's performance toward the largest, most valuable stocks, is off by 5.4%.

-Joseph Adinolfi

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10-30-23 1108ET

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