How to Handle the Market’s Correction

The Market’s Heading Down …
 
What to do?

One Stock from my Watch List

The biggest thing in the investment universe the past couple of weeks is that the U.S. markets (and most of the world markets) have fallen into a correction.  And I know the common question right now is:  What should I do?  Obviously, I can’t give personalized advice when writing this to so many of you, and I also can’t go through dozens of stocks (that’s what our publications are for).

What I can do is answer some of the most common questions I’ve been getting from subscribers in recent days.  So let’s get to it.

Question: I own XYZ stock, which has a great fundamental story. It’s down 35% or more from its high, including moving nearly straight down in recent days.  I had a decent gain but now I have a large and growing loss.  What should I do?

Answer: I touched on this in my weekly stock market review video on Monday.  In my mind, yes, the odds are favorable that your stock will bounce at some point, but when?  My advice is to take some action by selling some of your shares now, and then looking to sell the rest.  Taking action puts YOU in control … instead of just hoping every morning that your stock will begin its long-awaited bounce.  So, especially if you have a big position relative to your portfolio, I would advise selling some and looking to get out of the rest on a rally of a few percent or more.

Follow-up Question: But I can’t sell now!  I have a big loss!

Answer: Well, you have the loss whether you sell the stock or not … but I do realize that most of these fast movers don’t just head straight south.  They bounce, and some of those bounces are fast and powerful.  That’s why I favor a measured approach-sell maybe half of your shares just to ensure a bad situation doesn’t turn into a truly awful situation.  But holding some is fine, as long as you’re willing to let go of some more of your shares when the stock does rally for two or three days.

Question: I’ve been watching XYZ stock for a few months while it was rocketing higher, and now I’ve noticed that it’s now down 35%.  Isn’t it a bargain now?  Should I be buying?

Answer: No!  In this scenario, the stock is showing outsized and abnormal weakness.  And you have to remember that XYZ (like most stocks) has had a monster run in recent months, which means there are pent-up selling pressures in the stock.  Obviously, many of those pressures are being released (hence the 35% drop), but there are plenty more people who own the stock at much higher prices that want to get out.  If anything, stocks that break their 50-day lines on huge volume after big advances are better sells than buys the first couple of times they attempt to rally.

Follow-up Question: But then what should I be buying?  After all, the market is down a few percent and many stocks are down more.  So bargains abound.

Answer:
One of the bigger fallacies is that, to make big money, you have to be “first” in and buy before a big upmove begins.  Wrong!  In the current environment, the sellers are in control, so your best move is to hold some cash and, most important, look for growth stocks that are resisting the market’s downward pull.  Such action means big investors are hesitant to sell, which, in a poor market, really tells you something.

Follow-up Question: OK … so should I buy those growth stocks that are holding up well?

Answer:
A couple of small, pilot buys in certain resilient stocks is fine, but for the most part, you want to watch and wait.  As I often say, in poor markets, good stocks can go bad in a hurry.  We’ve already seen that to some extent-many names that held up well during the first few bad days came unglued late last week.  Thus, it’s usually best to limit new buying, though like I said, a couple of small positions here or there could work out.

Question: You talk about raising cash by selling your worst performers.  But what about my winners?  Shouldn’t I actually book some profits instead of booking all losses during this time?

Answer: I do believe you can book some winners … but you should discern which winners to sell.  For instance, if you have a big profit, but the stock is acting funky (like Apple was last week, flopping all over the place following its earnings and iPad announcements), or if the stock is extremely extended to the upside, or if earnings are coming out in a few days, you could take some off the table.  But in general, you should be hesitant to sell all of your best-performing stocks, as they have the best chance to lead the market’s next leg up.

Question: You’ve said that we’re likely in a short- to intermediate-term correction.  How do you know that?  How do you know this isn’t the start of a new bear market?

Answer: Nobody knows the future for certain, so yes, there’s always the possibility that this is the start of a prolonged bear phase.  But there are a few indications that this is not the start of a new bear market-mainly that the broad market, measured by both the Advance-Decline Line and the number of stocks hitting 52-week lows-did NOT diverge from the indexes at all.  And at major tops, you usually see months of diverging action.  Throw into the mix that bull markets rarely up and die after just 10 months (the duration of this one), and in my view, the odds heavily favor this being a correction, not a new bear market.

Follow-Up Question: OK, but if this isn’t a bear market, how long will this correction last?

Answer: Again, no one knows the future.  But studying past intermediate-term corrections, there are usually two or three legs to the decline.  The first leg (which we’ve probably already finished) is a phase where most investors are in disbelief; they feel it’s just a pullback within an overall uptrend.  The second leg down (after a bounce) is when most investors figure out something is really wrong.  And the third leg down, if it happens, is when people start panicking out to get out and believing a new bear market is upon us.  Thus, my best guess is that this correction is in its early or middle stages (call it the third or fourth inning?), though we’ll just take it day by day.

My last point here isn’t a response to a question, but just something for you to keep in mind while this correction grinds on.  What’s likely going on here is that the market and most stocks had such strong rebounds during the past 10 months that they’ve already discounted lots of the good news that’s now being reported (both in earnings reports, and in economic releases).  But that’s not the end of the world.

In fact, these corrections are actually fruitful in the long run, as they (a) allow you to identify the strongest stocks (those that aren’t going down) and (b) they allow those strong stocks to build new launching pads by scaring off the weak hands and setting the stage for another multi-month upmove.  So now is the time to sit back, take a deep breath, and work on building your Watch List for the next upmove … whenever it begins.

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So, you’re probably asking, what is on my Watch List?  Right now, I’m focused on getting back to basics … looking for strong stocks with great sales and earnings growth, big profit margins and (very important!) a solid story that is likely to continue those earnings trends in the quarters to come.

Moreover, I’m attracted to stocks that have been building launching pads for many weeks or months, as opposed to stocks that have motored higher for 10 months.

On that front, I’ll highlight two stocks I’ve been keen on for a while, yet the stocks (and their group) just never got going last year.  But now, it looks like the tide may be turning.

I’m talking about restaurant stocks, but specifically, “new idea” restaurant stocks that aren’t already so big that they’re destined to grow a measly 5% a year.  My two favorite ideas in the group-Chipotle Mexican Grill (CMG) and Buffalo Wild Wings (BWLD)-have tons of expansion potential in the years ahead, which, combined with growth at restaurants already open, should drive earnings sharply higher.

Chipotle Mexican Grill is aiming to re-invent the fast-food business with its simple Mexican fare.  Its hitch is fresh, quality ingredients as well as quick service-most of the firm’s beef, chicken and pork is naturally raised (no hormones, etc.), and much of its vegetables are organic.  More important, the food is good!  Management is also top-notch (the firm was originally a subsidiary of McDonalds before being spun off in 2006), and should be able to guide the firm from its current 900-plus store count to a couple of thousand in the years ahead.  Revenue growth has been humming along at a 15% clip, but earnings are expanding much, much faster (up 49% and 83% the past two quarters).

Buffalo Wild Wings’ (BWLD) is aiming to be a national sports bar of sorts, a novel idea.  The firm makes a lot of its money on alcohol, thanks to its fun, cozy atmosphere, yummy wings (including a dozen different sauces) and crew that is told not to force customers out the door.  The firm currently has 652 stores in 42 states, but management believes 1,000 stores in the U.S. is easily achievable, followed by expansion overseas.  Revenue growth is running in the 25%-plus range, with earnings a little faster.  

Both stocks have been building bases since the middle of last year but have perked up in 2010 despite the soggy market.  Also, both are reporting earnings on February 11.  Assuming both stocks get through their earnings reports unscathed, my thought is that they have strong upside in the months ahead as money flows into the fastest-growing companies in this group.

All the best,

Mike Cintolo

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