The Best Way for Investors to Play the Rest of 2010

You may think stocks are still attractively priced after the recent rebound — but that doesn’t matter. Instead, it’s more important what your peers think and do. Because if you’re buying while they’re selling, you’ll lose.

And right now, many of your peers have a solid excuse for selling: year-end profits. The S&P 500 has risen nearly +15% since early September, and many individual stocks are up +40% or even +50% from the summer swoon. With a hike in the capital gains tax expected next year, many investors will look to secure profits now instead of later.

As my colleague Ryan Fuhrmann noted back in September, the capital gains tax rate will rise from 15% to 20% in 2011. Investors can avoid capital gains by generating offsetting capital losses, but after the market’s massive 20-month surge, there are fewer losers to be culled from investors’ portfolios.

#-ad_banner-#If investors start to tiptoe toward the exits, it could quickly morph into a larger move. Just like we’re seeing in the current rally where success begets success, failure also begets failure. The market seems to be locked into mini-cycles characterized by broadening rallies (March and April of this year), a broadening slump (June, July and August) and a second broadening rally (the last two months). And as I noted recently, we could easily morph back into a pullback that takes on a life of its own.

If that tidy little scenario plays out, then we’ll be nicely set up for the “December effect,” which many investors recall was once known as the “January effect.” A study done in the early 1980s that searched back to 1925 found that stocks tend to post impressive rallies into the middle of January (after having sold off in the prior month due to tax-loss selling and other seasonal factors). As investors got wise to this trend, they jumped the gun to get in earlier, and stocks started to make their move in early December, not early January.

As this chart shows, December has generally fared better than January in the past seven years.

In that time period, the S&P 500 has risen an average of +1.7% in December while slumping -2.2% in January. The effect of much stronger Decembers has been especially noticeable the past three winters.

The wash-sale rule
Some investors that still like a specific stock that has underperformed may look to sell it to offset booked profits in another stock. But the I.R.S. makes you hold off 30 days before re-purchasing the lagging stock in order to stay in compliance with capital gains laws. So with an eye toward the December effect, they sell in November so they can buy that stock back in December, performing what’s known as a wash sale.

Action to Take –> If you don’t want or need to re-jigger your portfolio, investor caution is still warranted with the market’s recent rally and all the uncertainty around politics, the Fed and unemployment. I still believe that Mike Turner’s suggestion to buy the ProShares UltraShort S&P 500 ETF (NYSE: SDS) is the right move, though as Mike later noted, that move was a bit premature.

Now that move looks much timelier. After rocketing from 1050 at the start of September to a recent 1185 early last week, the S&P 500 has started to wane in the past five sessions. A sideways chart for this index is often a harbinger for a directional change in the market. There’s nothing wrong with building up some cash now so you can profit from the December effect later on.

P.S. — Any analyst can tell you they like a stock. But how many are willing to put their money where their mouth is? StreetAuthority Market Advisor is so confident in Nathan Slaughter’s picks that we gave him $100,000 in cash to put into his recommendations. Learn how you can join in and profit along with him.