The Coming Great Liquidation and The Opportunity

At WSJ, Andy Kessler makes a number of important points with regard to the market between now and the end of the year.

First, we are likely to see huge tax selling. Stocks that are down will see even more downward pressure between now and the end of the year, as investors sell stocks that are down to lock n tax losses.

And this goes for mutual funds as well. Kessler writes:

Mutual funds are also dumped for tax losses. When the stock market is down in the morning, it's usually because of mutual-fund redemptions.

Fidelity's giant Magellan fund, down 56%, is one of many in the $6 trillion stock-fund business having an awful year. As investors call or click to get out of these funds, Fidelity and the others have to unload shares the next morning to raise cash. This forced-selling overwhelms the system. New York Stock Exchange specialists, who are supposed to maintain an orderly market, stop buying and back away. You get huge drops, which can unnerve even more investors and cause them to redeem.

The redemptions could also cause huge legacy capital gains for some mutual fund investors. Kessler explains:

To make matters worse, in December mutual funds do capital-gains distributions. In a down year like 2008, you would think there are no taxes to pay. Think again. Legg Mason's Value Trust, run by Bill Miller, outperformed the market for 15 years by buying many "unvalue" names like Amazon. As investors redeem, he is forced to sell many of these stocks originally purchased at very low prices, triggering huge capital gains in a year his fund is down 62%. You can almost guarantee investors also will sell more of these funds to pay their unexpected tax bill.

Here's something the lame duck Congress should do immediately, temporarily lift the tax on capital gains distributions made by mutual funds to provide relief from these legacy capital gains.

And then, of course, there will be hedge fund liquidations because of the advisor fee structures at the funds. Kessler again:

...when hedge funds are down for the year, they work practically for free until they make up the loss. We'll see hedge funds close and stocks liquidated as -- no surprise -- hedge-fund managers like to get paid.

Bottom line, there is going to be huge technical downward pressure on some stocks between now and the end of the year.

Given that the Fed appears to be expanding money supply again, this should mean a huge "January effect" for January 2009. In a normal year, the January effect occurs as the technical selling pressure from the end of the year stops, often within a matter of days some stocks that faced huge selling pressure jump by 25% or more after the first of the year (Sometimes the climb starts the last few days of the old year).

With all the technical liquidations going on this year, watch the new low list carefully. Look for stocks of companies that are backed by solid operations and a solid balance sheet. If they appear to be going down for no reason day after day, it could very well be technical end of year selling pressure. Some of,these stocks will have huge rebounds, maybe 50% or more, within the first few days of January 2009. It will be a great opportunity, make your entire trading profits before February 1 and take the rest of the year off. It's going to happen for some.