Five Stocks for the Year-End Rally

The power and speed of the recent rally -- certainly including today -- is likely the result of money managers, having looked at flat returns for the bulk of the year, chasing prices somewhat indiscriminately higher as they look to bolster year-end performance. There is no reason to expect this run will end at a particular price level or prematurely just because it started earlier than the "traditional" year-end rally. The best stocks to pile into and drive higher are small-caps, which already have momentum in their favor and short-sellers on the run.

Rather than the broad market play of buying into the Russell 2000 or its ETF, the Russell 2000 iShares ( IWM), I'm looking to really give myself over to this parabolic move and try to ride the best performers right through New Year's celebration.

I ran a simple screen for stocks with a market capitalization between $500 million and $1 billion that have gained more than 50% for the year and have shown a double-digit percentage increase in the short position. I also set the range of daily minimum volume between 100,000 and 1 million to eliminate some of the names that are just too illiquid for money managers to have a meaningful stake, or those in which it would take an unusual commitment to drive the price higher.

The screen produced over 100 names, which was whittled down to 78 when I added the short interest parameter (which required an additional screen and some manual checking). And because I want to buy calls, rather than the underlying shares, I was able to reduce the list somewhat to a more manageable 37 names by only considering stocks with exchange-traded options.

Using options will not only require less capital outlay and supply more leverage, but will also offer a limited risk equal to the cost of the call. In addition, given that current volatilities are trading at historically low levels, and since the time frame for the January-effect trade is very specific and short, the time erosion shouldn't be too severe as we will look to exit the trade on Jan. 7 or the first Friday of the month.

I've furthered winnowed that list down to my top five names that, based on charts and current momentum, look like the best candidates to keep running through the end of the year and might provide some good speculative profits:

The (Potentially) Fab Five

Companies leveraged to commodity prices have been among the best-performing stocks and are likely to see a continued flow of money into the group. Century Aluminum ( CENX) is among those benefiting from increase in demand and a rise in metal prices. After a sharp pullback last month Century is climbing back above its 50-day moving average; a close above resistance at $26 would be very constructive and could set up a run to taking out the 52-week high at $29.21.

Despite jumping some 65% in the last five months, shares of Electronics Boutique ( ELBO) are still reasonably valued at just 18 times trailing earnings. The company is a leader in the high-growth video-game sector and is projected to earn $2.29 per share in its current fiscal year, which would represent a 34% increase over the year-ago period. With holiday spending looking robust and consumers focused on electronics, Electronics Boutique looks like it could deliver better-than-expected results.

Paxar ( PXR) provides management tools and merchandising services for retailers and stands to benefit from a strong holiday season, as well as the trend of retailers toward greater efficiency in the supply chain and increase cost controls. The stock is looking to hit a new 52-week high and a close above $24 would be constructive. The January $25 call is currently trading at $0.50 cents, giving it an implied volatility of just 26%, which is just above the 52-week low of 24.8% hit in September.

Red Robin Gourmet Burger ( RRGB) has been a classic small-cap growth story and right now it is just feeding off its ability to increase top line growth by opening new locations. The stock is in the darling phase and will likely have room to run up (and over the shorts) for some time.

WH Energy Services ( WHQ) has performed well along with the many other energy names. As the stock nears support at $22 it could present a buying opportunity. The January $22.50 calls for $80 cents with the stock at $22.25 represent a good low-risk way to buy into this recent pullback.

Statistical Based Faith

The above picks are made in expectation of the year-end's bounty of seasonal patterns, for which some clarification of terms could be helpful.

"The Santa Claus rally" refers to the belief that stocks tend to go up during the last five trading days of the year and the first two days of the New Year. Its record is somewhat dubious, and its existence is probably the result of the happy coincidence that December has historically been an up month, logging gains in 80 of the last 105 years, according to The Stock Trader's Almanac.

Still, the phrase "if Santa Claus should fail to call, the bears may come to Broad and Wall," has become ingrained in Wall Street lore.

Another term, the January barometer, essentially holds that the direction in which stocks move in January will set the trend for the upcoming year. This is often confused with the January effect, which is the tendency for weaker stocks to outperform large-caps during the early part of the New Year, often after slouching in December amid tax-related selling. RealMoney.com contributor Alan Farley presented a strategic approach for capitalizing on this seasonally identifiable pattern here last week.

The January effect has traditionally been most powerful for small-cap stocks. According to a research report by Dr. Albert Richards, a small-cap market strategist with Smith Barney, over the last 15 years, small-caps -- as measured by the Russell 2000 Index -- have gained an average of 4.9% during the 30-day period from Dec. 15 to Jan. 15 vs. an average of 1.98% for the S&P 500 during that same period.

However, Richards' research also shows that a sharp shift occurred in 1993, which created a clear demarcation for when the bulk of January-effect gains have been realized. From 1979 to 1993, the small-caps outperformed the large-caps by an average of 3% during the first 10 trading days of January. But since then, the Russell 2000 has actually underperformed by an average of 0.8% for the Jan. 1-Jan. 10 period over the last nine years.

But like all things in this modern world, time has moved forward as people look to get ahead of the curve. "The January effect did not disappear -- we believe it just moved to December," Richards wrote in his report. His research shows that since 1993, the Russell's relative outperformance occurs from Dec. 20 to Dec. 31, averaging an impressive 2.36% during this short trading interval. The recent rally, in which the Russell has gained 14.4% for the year to date, and a huge 9.5% in just the last four weeks, makes playing this phenomenon more difficult this year.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

If you liked this article you might like

The Influence of Option Expiration

The Influence of Option Expiration

Options Mailbag: Short the Transports

Options Mailbag: Short the Transports

Options Mailbag: Not All Merger Strategies Are Created Equal

Options Mailbag: Not All Merger Strategies Are Created Equal

Lehman's Options Plays Suggest Fear

Lehman's Options Plays Suggest Fear

Three Potent Tech Options Plays

Three Potent Tech Options Plays