You've Got Questions, We've Got Answers

 
This is a dangerous time for investors, but it's only partly because of what the bear market is doing to your portfolio.   In my experience, these are the times when investors tend to stray far outside the bounds of any normal, prudent system; they do exactly the wrong thing at exactly the wrong time.  And that's what really kills them.

Why does this happen?  Because when movements in the markets become extreme (on the upside or downside), emotions ratchet up.  And when emotions ratchet up, investors want to do something ... almost anything.  Instead of patiently waiting and calmly analyzing the situation, too many investors fall prey to the lure of a volatile stock market.  And they start doing things that cost them oodles of money.

In today's Cabot Wealth Advisory I'm going to address many of the questions I've received in recent days and weeks--another Q&A of sorts that will touch on some of the mistakes I'm seeing out there.  And I'll also touch on the market itself, with some views of the current environment, as well as how you should go about riding the next bull.  I hope you find it interesting ... and profitable ... but whether you do or not, or if you have more questions, send us an email or comment on our blog, http://www.iconoclast-investor.com

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Question: I still own a bunch of stocks and mutual funds right now.  Is it too late to sell?  Or should I dump them?

Answer: This is the most popular question I'm getting these days, so if you're in a similar boat, don't feel ashamed--you're certainly not alone.

Here's what to do:  First, if you own a ton of stocks that are broken and are showing you big losses, you should start selling something.  It doesn't have to be a lot, but trust me, taking some action--even if it means selling one-quarter of your holdings, or just dumping a couple of stocks outright--will make you feel better.  You won't just be sitting there and hoping the market will go up.  You'll be taking matters into your own hands.

With the rest of your holdings, try to sell pieces during rallies.  Don't be greedy; don't try to get all your profits back.  Just unload another chunk of stock if the market rallies for a couple of days, or if your stock pops higher.  Over a period of a few weeks, you'll gradually get out of your broken stocks and, eventually, when our indicators give the green light, you'll be able to move into the leaders of the next bull move.

As for mutual funds, I have less concern about them, assuming they're broad-based (i.e., not sector funds) and have a decent track record.  Funds will come back when the market does, but many individual stocks will not. 

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Question: I'm a long-time subscriber to Cabot Market Letter.  I'm curious what you think of XYZ stock.  It's down 70% from its peak, is a good company and is trading at a P/E of 10.  Isn't it a bargain?

Answer: The temptation to buy cheap is something that will always be with investors.  Heck, I even fall prey to it from time to time, mesmerized by a seemingly great product, excellent management and a low valuation.

However, in most cases, these "good company, low P/E" stocks are what I call "valuation traps."  Everything appears fine, management looks good and the stock is cheap as dirt.  So you buy it, expecting that the stock will begin to go up.  But it doesn't, it continues to fall week after week, as forward-looking investors downgrade their expectations.

The problem: there are dozens of institutional investors who are selling shares hand over fist (that's why the stock is off 70%) despite the low valuation.  Many of these big fish are smart investors; they're well aware of the low P/E ratio ... but they're also forward-looking, and are in most cases aware that business in the future won't be as good as expected.  And that's what counts.

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Question: I'm looking at a ton of stocks that are now sporting dividend yields of 4%, 5%, even 7%.  Do you think it's a good time to begin nibbling on these shares?

Answer: This is sort of a corollary of the last question.  However, dividends are more meaningful than earnings because they put cold, hard cash in your pocket.  It's true that many big investors often support stocks that show big yields, even during tough markets.

If you're delving into some of these names, you should favor dividend stocks that have stabilized for a few weeks, and that have shown some increases in sales and earnings in recent quarters, as well as stable, solid projections going forward--no small financials or steel stocks, thank you.  It's not as easy as simply buying the biggest yield you can find; in fact, the highest yielders are usually among the riskiest investments.

However, for the investor with a broad portfolio--and who's already holding plenty of cash--nibbling on a few stable dividend payers now that the market is down 40% from its highs could work out well.  One stock that intrigues me on this front is Verizon (VZ), a huge Dow component that reacted well to its earnings report this week, and has a yield of nearly 6%.  Take a gander if you're interested.

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Question: You've been looking for a re-test of the market's lows.  Does last week's decline, followed by this Tuesday's 889-point Dow upmove, qualify?

Answer: Historically, every major market bottom has a re-test--that is, the Dow hits a low, rallies for a couple of weeks, and then falls back down to test the level of the initial low.  If the low holds, then there's a chance the market will see a big rally ... sometimes a new bull market.

In the past, this re-test process has generally taken within 27-35 days; about five to seven weeks.  The most recent example was the re-test earlier this year--the market bottomed in late-January, and then re-tested the low in mid-March (when Bear Stearns went to investment bank heaven).  That one took 38 trading days.  After the 1987 crash, the re-test process took 34 days.  Most take about that long.

Thus, the current re-test process is a bit short in my view (just 12 days) ... but then again, nothing about this market has been ordinary.  Given the mini re-test, and Tuesday's big up day, I think there's a chance for a solid bounce in the market indexes, possibly up to their 50-day moving averages.  Yet there's a still lot of repair work to be done among the indexes and individual stocks, so I'm still of the mind that there's going to be more backing-and-filling required before a sustainable bull move gets underway.  Either way, with our market timing indicators still negative (the trend is still down), I'm doing little but watching and researching right now.

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Question: Given your trend-following indicators, you're not likely to get a buy signal for a few weeks after the bottom.  But considering the horrible news, the rally is likely to top around then!  How will you prevent your indicators from giving a buy signal at the top of a rally?

Answer: Whoa!  This is what I call the curse of preconceived notions.  First, no one knows whether the next rally will be a bear market rally, or a new bull market, or just a two-day bounce.  Second, no one knows when a buy signal will come; true, it's never at THE bottom, but sometimes it's just a few days later, other times, many weeks. 

This type of thinking is like the host who, when planning a  big function, worries himself sick over every possible thing that could go wrong--too many people, not enough refreshments or food, not enough parking, some people might not show up, etc.  He's looking too far down the road instead of just focusing on what he can control.

While it's good to be prepared for different scenarios in the market, you shouldn't go around assuming the next three months or longer are going to happen according to your script.  It doesn't work that way.  Just take things day by day, week by week, and you'll come out much better.

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Question: What are some prudent ways of shorting stocks if this downtrend continues?

Answer: Shorting is more difficult than buying for one main reason--fear is a more intense emotion than greed, and thus, drops tend to happen more quickly than rises.  That means your timing on short sales must be more precise than your timing on long investments.

Still, shorting can be done profitably.  The keys are: To short past leaders that had huge upmoves, are well known and very liquid; to short only after a definitive top in the stock (and the market) is in place; to short AFTER a multi-week rally, generally up to the 50-day moving average; and to take both losses and profits quickly.  You don't want to wait around for a huge rally in the stock; you're better off nailing down 20% to 30% profits on the short side.

The other option, if you want to take out the risk of individual stocks, is to short exchange traded funds (ETFs) of indexes like the Dow or S&P 500, or if you want more risk, buy the inverse ProShares of those same indexes (symbols DXD and SDS, respectively).  Again, just remember to short after rallies, not after a few weeks of declines.

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Question: I've waited patiently for a new bull market.  Once it arrives, what's the best way to take advantage of it?  Should I become fully invested immediately?  Buy leveraged ETFs?  A mixture of both?

Answer: There is no one perfect way to play the market ... but the key is to have a game plan going in.  For my part, I'm a big fan of taking things slow. I know most investors, especially if they've waited out much of the bear market on the sideline (as have my subscribers), are eager to get back in, and make sure they don't "miss the boat."

But I've got news for you:  Any new bull market is going to last months and years, not two or three weeks.  And my studies of the past have shown that many of the best winners don't come off the launching pad until a few weeks after the bottom.  That is certain to be the case this time around, as the number of good-looking growth stocks capable of leading this market higher is currently tiny--I would say fewer than five.

Thus, when buy signals come, it's best to put some money to work, and then observe.  If your stocks don't go up, don't buy any more.  But if the market acts well, and your new purchases get off to good starts, you can look to average up on those purchases, or add another stock or two to your portfolio.  And then go from there.

As for what to buy, that's really a matter of personal preference.  I like to find individual stocks that can double, triple or more at the start of a new bull market.  And I run a fairly concentrated portfolio--usually no more than eight stocks.  But there's nothing wrong with using index or sector ETFs, but the same principles apply; cut all losses short, let winners run, and only buy more if your portfolio is advancing.

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All the best,

Mike Cintolo

Editor's Note:  How did your portfolio do during the market's crash?  Were you caught flat-footed, or were you safely on the sideline?  Subscribers to Cabot Market Letter, edited by Michael Cintolo, were nearly all in cash--thanks to his time-tested market timing indicators, the Letter's Model Portfolio has been more than 90% cash since early September!  Mike knows how to spot bull markets, too (he was up 37% last year, and has outperformed the S&P 500 by a stunning 55% since the start of 2007!), and he's now gearing up for the next upmove by honing his watch list and keeping a close eye on his indicators.  If you want to be in early in the next bull move--and to avoid any future pitfalls--you owe it to yourself to give Cabot Market Letter a try.

http://www.cabot.net/info/cml/cmlim03.aspx?source=wc01

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Michael Cintolo can be found on Google Plus.

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