‘Playing bounce’ can be costly

It’s called “playing the bounce,” a stock trading strategy that sounds like light entertainment, but isn’t.

This time of year, some traders try to take advantage of the tendency by fund managers to dump some of their ugliest stocks. The fund managers cleanse stock portfolios before the end of the year so unsightly stocks — such as homebuilders and mortgage companies this year — don’t show up in year-end reports and scare off investors. Also, by selling losers in October, mutual funds reduce taxes clients must pay, offsetting the capital gains that winning stocks would otherwise leave at tax time.

Individuals sell for tax purposes, too — usually more heavily in November and December.

All the selling creates the opportunity for the bounce strategy, in which investors buy stocks that have fallen sharply from their peaks earlier in the year.

Stocks often weaken during autumn but then frequently climb — or bounce up — as investors anticipate a fresh start just before year-end or in January. So traders rummage through the stock market’s garbage amid the selling during the fall and buy stocks in the hope that they will be able to partake in a bounce and get out fast.

The idea is to pocket a quick buck, rather than to buy and risk another downturn.

But people who dig through the rubble can end up merely holding trash. The bounce strategy, which has been tracked by analysts such as the Stock Trader’s Almanac and the Leuthold Group for three decades, doesn’t always work. And Leuthold warned clients recently that this year might be one of the years when it doesn’t pay to play.

While an investor would have made more money during the last four years buying year-end sludge instead of a Standard & Poor’s 500 index fund, a Leuthold report says the maneuver appears excessively risky this year.

The firm’s list of bounce stocks is dominated by financial companies and homebuilders — stocks where bad news continues to flow even though home builders such as Beazer Homes, D.R. Horton and KB Home were on last year’s bounce list and large banks have reported sizable losses from the subprime lending fallout.

“Clients who are astute stock-pickers may enjoy the challenge of picking a bottom in some of these stocks, but this is no easy task,” said Leuthold analyst Andy Engel.

To qualify for the bounce list, Leuthold required the following declines from 2007 peaks: large-cap stocks down at least 25 percent; midcaps, 35 percent; and small caps, 50 percent.

Homebuilders are by far the worst area of the market — down about 50 percent for the year, according to Leuthold data. The builders climbed about 11 percent in September after a rate cut by the Federal Reserve gave investors an optimistic breather. But after dreary reports on the housing market, builders dropped again, giving up what they had gained.

Financial companies, too, gained amid the relief from the Fed’s 0.50 percent rate cut. But the stocks headed down again recently as investors digested sobering words from Fed Chairman Ben Bernanke and hidden weaknesses in financial institutions became somewhat exposed.

Of course, trying to take advantage of a year-end or January bounce would be a different strategy than buying for the long-term.

But even that gives Leuthold researchers concern.

Last year, playing the bounce provided investors an 8.6 percent return from Oct. 1 to Jan. 31, compared with the S&P 500’s 7.9 percent return. But the makeup of those bounce stocks was very different than this year’s group. Many were energy and commodity stocks that slumped as investors apparently decided to sell in case the economy slowed in the coming year. This year, the homebuilders and financial stocks already are in the midst of a mess.

XGail MarksJarvis is a personal finance columnist for the Chicago Tribune. Contact her at gmarksjarvis@tribune.com.