Flexible Investing in a Volatile Stock Market

This past Sunday, as I have for 18 of the past 20 Sundays (there have been two bye weeks), I watched my hometown and much-loved New England Patriots, who slugged it out with the San Diego Chargers for three hours. In the end, they emerged victorious to win the AFC Championship, and earn a berth in Super Bowl XLII.

As an NFL junkie, this season has been particularly fun because the Pats are looking to make history; if they’re fortunate enough to win the Super Bowl, they’ll finish the year 19-0, the first NFL team ever to do so.

But it hasn’t always been a smooth ride. Early in the year, the team was blowing teams out week after week; it beat the Jets 38-17 to start the season, pounded the Redskins 52-7 in late-October, and creamed the Bills 56-10 on November 18. But then something “strange” happened – the games started getting tougher!

The Pats squeaked by the Eagles and Ravens in back-to-back weeks, nearly lost their perfect season against the Giants on December 29 (they’ll face them again in the Super Bowl) and struggled Sunday against the Chargers, putting up just 21 points, the team’s second lowest total of the season.

What happened? The competition adjusted … but so did the Patriots. Instead of airing it out all night long, the Pats have become a bit more balanced, throwing lots of short passes, running it more frequently and switching it up on teams. Opposing foes continue to come close–it was 14-12 during the fourth quarter this past weekend–but none has closed the deal.

In my view, if the Pats are going to make history, it’s going to be because of their ability to adjust and be flexible, both in formulating a different-looking game plan, and in making changes during the game itself.

Stick to Your Investing System

It’s really similar with investors – the best ones are flexible and realize that the market is always changing. I talk to way too many people who do things one way and one way only; in some (maybe most) market environments, their methods work fine, but when something out of the ordinary occurs, they lose a ton of capital and, even worse, their confidence.

Of course, I’m seeing that occur as this bear market (or correction, or bear phase, or whatever you want to call it) unfolds. What these people forget is that the market is dynamic, just like opposing teams and coaches. It’s constantly changing shape, because the people involved in the market are constantly changing opinions, and their emotions swing back and forth. So the same tactics that worked two months ago might fail miserably this month.

That doesn’t mean you switch up your core investing values. There’s no reason to go from growth investing to value investing to fixed-income investing to short selling–nobody can do that with success. (Jack of all trades, master of none …) In my case, I will always and forever lean toward growth stocks with sound chart patterns showing good volume clues.

However, in some environments, I might give my stocks plenty of rope, figuring that any retreat is likely to be a buying opportunity. Later in a bull move, when mistakes tend to be severely punished, I might be more willing to sell a piece of a winner on the way up, or cut my losses even tighter on the way down. And in a bear phase, like now, I’ll do little if any buying until the market shows signs of turning for the better.

Now, if the above paragraph leads you to say, “Duh!,” then pat yourself on the back–you’re already ahead of the game. But if you’re wondering why you’re unable to consistently make money year in and year out, realize that flexibility is one of the keys to being a great investor.

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What Not to Do

An example of what NOT to do comes from one subscriber, who admitted the following:

“I’m in FSLR, down 20%, DRYS down 40%, SGR down 23%, FXI down 19%, ISRG down 14%, RIMM down 20%, FWLT down 16%, WFR down 24%, ACH down 30%, MOS down 14%, BIDU down 17%, WYNN down 14%, etc. I’m fully invested and into margin. I stayed in thinking things would come back with fed cuts and upside earnings surprises. But it looks worse and worse. I’d hate to lose all that money of course. Will they come back?”

This investor was inflexible, not respecting the market’s (and his stock’s) messages. (The most powerful message you get from a stock is its own price action.) And this fellow isn’t alone – there are surely thousands of investors who have been caught with their proverbial pants down, frozen with shock at the sight of their stocks falling so rapidly and consistently.

So what are you to do if you’re in a similar situation – that is, if you haven’t been flexible? Get flexible! That doesn’t mean panic and sell everything, but it’s usually best to sell a few of your worst performers (biggest losers), forcing yourself to respect the message of the market and your stocks. Then look to sell more on any bounces – the goal is to not lose more money than you already have.

Another common mistake investors make during emotional times is, well, becoming emotional. Panic selling is the obvious example, but more common is the urge to pick the bottom. Over the past few weeks, I’ve answered numerous e-mails asking whether it was time to buy, especially this past Tuesday.

My answer: The market appears ripe for a short-term bounce … but so what? The reason most people want to pick bottoms isn’t really to make money; that’s part of it, of course, but not the sole purpose. The reason they want to pick bottoms is to feel like they outsmarted the market and most other investors. There’s nothing shameful about that, but in the market, wanting to prove that you’re right usually costs you money.

Long story short, when the “unusual” is happening, it’s vital to have a system that works, that’s proven, and that you have enough confidence in to follow. Without one, it’s just a matter of time before the market takes away your money.

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Now on to everyone’s big question: “What the %@&!#& is going on with this market?”

There’s no doubt we’re viewing something historic–the market has literally collapsed since the start of the year (actually, the decline began two days before New Years). It’s basically been a market crash occurring over a four-week time frame! Volume has been running at high levels as big investors dump shares en masse.

While this may seem like it came out of nowhere, in reality, the market was building a major top during the second half of last year. On numerous occasions, we wrote to subscribers about the divergence taking place; while the leading stocks I usually focus on (those with fast sales and earnings growth) were running ahead, more and more stocks and sectors were breaking down–retail, homebuilders, financials, travel-related, you name it.

Historically, such a divergence usually leads to a market correction. However, this divergence began in June and July of 2007 … and persisted right up through the end of the year. The underpinnings of the market were being chewed away for six months straight! And now we see a “powerful” kick-off to the downside, as the bear phase takes hold.

Of course, the recent disaster has produced a slew of oversold-type signals–for instance, 1,114 stocks on the NYSE hit new 52-week lows on Tuesday, or roughly one-third of the entire exchange. A mere 17% of all NYSE stocks are trading above their long-term 200-day moving average, one of the lowest readings in decades. And the volume of put options (which go up when the market goes down) is skyrocketing as investors seek portfolio protection.

Normally, such readings would have me thinking a turn for the better is right around the corner. And, in fact, I do believe a sharp, powerful bounce is likely after Wednesday’s huge upmove; it could last for many days or even weeks. But given the six-month topping process talked about above, I doubt that this downmove can end after just four weeks.

Also, you should always remember this: Bottoms are a process, not an event. No stock or market falls this sharply, hits bottoms one day, and then begins a new uptrend. Said another way, V-shaped bottoms are a myth; they almost never happen.

Bottom-Building Process

Now, in terms of positive news, the horrific action of the broad market could lead to the start of a bottom-building process in the market’s worst sectors – especially financials, which are likely to benefit from the Fed rate cuts. Even housing-related shares are catching a bid on strong volume – Ryland (RYL) has broken out from a 3 1/2-month consolidation as I write this. Bottom line: Some beaten-down financial, housing, and retail stocks could be near some important lows.

However, because many leading stocks like Apple (AAPL), Baidu (BIDU), Google (GOOG), etc., only recently topped out, I seriously doubt they’re near bottoms. Simply put, after advancing many-fold in recent years, these stocks have plenty of pent-up selling pressures from institutions that want to lighten up (or get out completely), which will tend to stunt any upside.

What about the economy, or the fundamentals of these firms? Well, I approach things as a student of the market – I’ve studied past bull market and bear market cycles, and know what they look like, how they “feel,” and what common characteristics they have. And those historical guidelines tell me that those popular leaders of 2007 have topped out, and should be sold on any rally.

But don’t worry, it’s not all doom and gloom – the truly great news about a bear phase is that it “re-sets” the market. Meaning that the next leaders aren’t already years into a major advance. They’ll be fresh, vibrant names, ready to deliver triple-digit profits.

There are few great-looking growth stocks these days, but Chipotle Mexican Grill (CMG), which has the potential to be the next McDonalds, and Accuray (ARAY), a company with revolutionary new radiation equipment for tumors, are two I’m watching. VMware (VMW) is another – it’s still the leader in a new, exciting industry (virtualization software for servers), and is twelve weeks into a base-building phase. I’ll be sure to talk more about these and other potential leaders in upcoming issues.

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Editor’s Note: Mike Cintolo is Vice President of Investments for Cabot Heritage, and editor of the Cabot Market Letter and Cabot Top Ten Report. Mike’s market timing indicators, which focus on the action of the market itself, gave warning signs in October, and have been generally bearish since November 8. The result: The Market Letter’s Model Portfolio has held at least 50% cash since mid-November, avoiding much of the disaster of recent weeks. That’s helped keep the long-term track record pristine – over the past 5 years, the Model Portfolio has more than doubled the return of the S&P 500. If you’d like to get proven, sensible market timing and stock selection advice, try a risk-free trial to the Cabot Market Letter today.

http://cabotinvestors.com/ecmlicwa17.html

Until next time,

Mike Cintolo
Cabot Wealth Advisory

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