How This Market Has Turned Me Into George Costanza

Includes: COG, HD, MIDD, SHW, V
by: Alan Brochstein, CFA

Ordinarily at this time of year I begin thinking about a typical December contribution that I share on Seeking Alpha regarding stocks to sell right at year-end to take advantage of profit-taking that usually kicks in as the calendar turns. I think I took last year off, because the gains weren't so abundant, but we are still up 8% YTD despite a nasty correction over the past 9 weeks. Given that this follows 3 1/2 years of rallying, with a few corrections along the way, I would ordinarily expect the tendency to persist: Winners stay bid through year-end.

This rule says to hang onto the winners right until the last minute, selling just as the year ends so that the next day and weeks you don't get run over by those who deferred selling for tax reasons or who hang onto the position to look good to clients by having the "winner" show up in their holdings. While this usually works, I am taking the advice of the legendary George Costanza and doing the opposite.

2012 isn't an ordinary year. With pending tax-law changes, people are selling. The maximum long-term gains is scheduled to jump from 15% to 20%, while ordinary income tax-rates that govern short-term gains taxes will likely rise for the highest brackets. While there is no penalty for just buying back (to book the gain at the low tax-rate but keep your stock), these stocks aren't finding that re-bid apparently. There's no exit survey when people sell stocks, so it's impossible to know their full thinking, but I do believe that the expectation of higher taxes is playing a role.

Here's an example of a stock that I sold last week from my Top 20 Model Portfolio: Middleby (NASDAQ:MIDD). I love the fundamental outlook, which is basically a highly focused company continuing to ride a long-term trend of restaurants upgrading their kitchens for faster cooking, less labor and increased energy efficiency while adding a whole new category of food processing (primarily for emerging markets). With that said, the last quarter was solid but didn't lead to a substantive boost to earnings estimates, and the chart looks vulnerable in this Costanza world:

(Click to enlarge)

This is a short-term gain for the model, as we got involved in June just below $100 right before it emerged from the six-month base. For many investors, though, it's a long-term gain - it bottomed near 20 in early 2009. The valuation is high, as the stock trades at about 18X 12-month forward estimated EPS. My guess is that the stock could grow EPS 15% or so and trade to 20-21X, so I would hope to get back in at a lower price or in a few months. For now, though, this seems like the kind of stock that the market likes to slam.

Perhaps my decision was a bit easier because the stock seemed a bit overextended to me (note how long it's been since the 50dma crossed the 200dma). It was also pretty easy to find a replacement stock, with the name I selected down 1/3 since hitting an all-time high in July. If you want to know what we bought, you can read my article that I shared in March. Hopefully our patience, which allowed a better entry, will be rewarded.

Most likely, MIDD isn't an example that resonates with you, as the chances are you aren't familiar with the company. I quickly screened the S&P 500 for some other potential accidents waiting to happen. There are 15 stocks (3%) that are both up 20% or more YTD and still within 4% of their 52-week high. I took a quick look for some of the best examples among them - these aren't sell recommendations, but they sure have the characteristics of stocks that would ordinarily be safe for the next 42 days or so:

  • Cabot Oil & Gas (NYSE:COG) was last year's best stock in the index and is up another 26% in 2012. It looks extended and is trading at what appears to be a high valuation. Plus, have you looked at other E&P stocks lately?
  • Home Depot (NYSE:HD) looks extended and is up 48% this year, with its 18PE rather steep compared to its history over the past decade, especially considering that its margins are at the highs
  • Sherwin-Williams (NYSE:SHW) is up 70% this year and has the highest valuation since 1998 at 20PE. Yes, I saw the big acquisition.
  • Visa (NYSE:V) is up 41% this year and over 100% over the past two years, again at a relatively high PE for the stock of 20X

This is obviously more of a tactical rather than strategic call. The fundamental stories here might be strong enough that you can resist the urge to sell. If you own some of these high-flyers, it might be worth it to be cautious about adding. In a year like this, there are likely plenty of losers to offset any gains that you may not want to take. George Costanza quickly reverted to his old ways after that single episode when he chose to go against his instincts, and I expect that this will be the one year where I agree as far as not waiting until 12/31 to exit winners for the seasonal trade.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.