Strategists recommend buying on rumors of tax reform, because 'people are going to sell on the news'

Breaking down investors’ tax reform playbook

Stocks closed at record highs last week as Congress released the final version of its tax plan. But some strategists are floating a classic market adage to describe the market's response to the pending legislation: "Buy the rumor, sell the news."

On Wall Street, "Clients have been literally positioning capital into tax reform plays since August, and even in the fall. So we think January, for a whole bunch of reasons, is going to be very rough," Larry McDonald, founder of the Bear Traps Report, said last week on CNBC's "Trading Nation."

Investors have piled into small cap, financial and industrial stocks this year, on the hopes of some sort of tax relief. According to McDonald, investors will likely wait until 2018 to harvest gains, in an effort to avoid paying taxes.

"People are going to take gains, and they're going to put off the gains until January… and people are going to sell on the news," he said. "I'm pounding the table… get long volatility for January because people are going to sell tax reform on the news."

Markets have hit successive new highs as investors anticipated a tax bill that would benefit corporations. Still, weakness has emerged as members of Congress have wavered in their support of the bill, and it now appears the market has already priced in the so-called "good news" as the legislation gets a final vote, then heads to the Oval Office for President Donald Trump's signature.

The markets' record gains this year have come with historically muted and virtually non-existent volatility — which McDonald warned could pick up in January.

"If [the bill] doesn't pass, it'll pass in the first quarter. So you've got a risk for volatility next week if we have a problem with these senators," he said, addressing key GOP members that have voiced concerns about the reform package.

"But then once you get it passed, you get an extreme high probability of volatility in January when people are just … the New Year is here, take your profits and a lot of this good news is priced in for tax reform," he said.

Other market watchers are more optimistic on how the market will receive the tax bill, should it pass. Craig Johnson, chief market technician at Piper Jafray, is bullish on the S&P 500 Index into 2018, and would buy any near-term pullbacks.

"Part of the playbook for us is: any dips, don't trip, continue to buy this market long, and we're looking for 2,850 by year-end of next year on the S&P," Johnson said last week on "Trading Nation."

Johnson recommends the financials, specifically the S&P financials sector-tracking exchange traded fund, the XLF, to investors.

"The XLF is acting very well on the chart. I think from here, you could see a move back up toward about $38," he said, implying nearly 37 percent upside.