Stay Flexible in the Stock Market

 
Shades of Gray--Don't Stick Your Flagpole in the Ground

First Things First

Looks Like ... 1998?

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In a way, writing a stock market newsletter is a bit like politics--you're serving a broad audience (some would argue many politicians serve no one but themselves ... but just play along with me) and every member of that audience has a different viewpoint on the market and certain stocks. So it's really impossible to satisfy 100% of my subscribers--if I can keep 80% happy, it's like a landslide win in an election.

This thought popped into my mind recently when I was responding to a couple of different emails in the same day. First, some background: In the Cabot Market Letter's Model Portfolio (which I edit), we had 35% cash at the market's July peak, hiked that toward 50% as the crash unfolded and, at the time I received these emails, was sitting on a massive (to us) 73% cash position.

With that in mind, let's get back to the aforementioned emails.  One was chastising me for being too defensive; after all, if I think there's a good chance the market is in a bottoming process, why not start loading up on stocks? He had been in cash but wrote that he was now nearly fully invested in some popular names at "bargain" prices.

The other email, though, had the exact opposite opinion--I was too optimistic! Having a quarter of the portfolio in the market was too much, as were any hopeful words for the future; he was net short and looking for much lower prices.

My point here isn't to pick who is right and who is wrong; time will give us an answer to that question. The real moral of this tale is that, when approaching the market, I have found it best not to think in terms of black and white, but instead, in shades of gray.  

The reason is relatively simple--the market is a dynamic and ever-changing animal, and if you plant your flagpole in the ground and declare "the market is DEFINITELY going higher from here!!" you might be right once or twice ... but eventually, you're going to get your backside handed to you. The same goes for being all-out, 100%, no-holds-barred bearish.

This is the reason why, whenever we get a new buy signal, I won't advise going from 73% cash to 0%; I prefer to take things gradually and let the market "pull" us into a more fully invested position by its action. The same goes for selling--we rarely jump out of everything at once, as that will leave you wanting more often than not.

To quote the legendary trend-following investor Ed Seykota from his interview in the first Market Wizards book, "I usually ignore the advice from other traders, especially the ones who believe they are on to a 'sure thing.' The old-timers, who talk about 'maybe there is a chance of so and so,' are often right and early."

In other words, those who have been involved in the markets for many years know that nothing is written in stone. So, especially during the current uncertain environment, remember to stay flexible and be willing to adjust to the evidence that comes at you.

Speaking of emails, one of the most common questions I get, especially after the market has suffered through a few bad weeks, is this: "I own XYZ stock at 50 and now it's 38.  I like the prospects but am sitting on a big loss; I don't want to take the loss, but I'm torn on whether the stock still has a bright future. Your thoughts?"

A variant of this email that I've received many times is, "I invested 30% of my portfolio in XYZ at 50, and now it's at 38. I can't take that loss! What should I do?"

I always give them my best analysis of the stock, its sector and the market.  But what I also throw in is, "Next time, make sure you have a plan of when to exit (either on the way up, or the way down), and plan out your trade ahead of time."

I've written about planning your trade and trading your plan a few times before, so I won't rehash all the generalities again.  Instead, I'll go through the process that I use when putting on a trade.

First, of course, I pick a stock I want to buy.  

Second--and this is important--I decide how much I want to risk on the trade. (That is, if I get stopped out for a loss, how much I am willing to lose.) This risk is in dollars, or, if you're more technical, maybe as a percentage of your portfolio.

Third, I figure out at what price I would like to buy the stock. This could be on a breakout above a base, or on weakness ... whatever system you're using.

Fourth, I figure out where I want to cut my loss if I'm wrong. This is usually 8% to 15% below the purchase price, depending on the chart, the market environment, etc.

Then and only then, after the first four steps, do I figure out how many shares I am going to own. I do this by dividing my risk (step two) by the difference between my buy price (step three) and my stop (step four). It sounds complicated, but really, it's simple.  Here's an example, assuming I have a $100,000 trading account (to keep the math easy).

Say I want to buy MAKO Surgical (MAKO). Given the still-choppy market environment, I decide to only risk losing 0.5% of my trading account ... the equivalent of $500.  

Then I pick a buy price; I think it would be decent to pick up some shares on a pullback to 34, as the stock is one of the few that actually hit new highs in recent days.  

Next, examining the chart, I think that a logical stop (not too tight, not too loose) would be in the 30 to 31 area. We'll call it 31, which would be three points below my buy price (around 9%).  

Now--finally--I determine how many shares I will buy. I take my risk ($500), and divide it by the difference between my buy price of 34 and my stop of 31 ... which is equal to three points. 500 divided by 3 = 167 shares. Voila! This calculation tells me I can invest $5,678 (167 x 34).

Moreover, I have a concrete plan on the loss side; if the stock falls to 31, I'm out with a $500 loss. No more agonizing about what to do if the stock heads south. (I'll talk about developing a plan to deal with profits in a future Cabot Wealth Advisory.)

Now, at this time, if you have an ice cream headache from all the numbers, my apologies.  You don't have to follow this exact procedure in your own trading, and frankly, I just picked the portfolio numbers out of thin air.  

But the value isn't in the numbers, per se, but in the process--it's best to first think about risk, and then think about entry points and stops. And also notice how my position size automatically adjusts given my risk, so I never find myself owning way too much of a position (and suffer a huge, portfolio-crushing loss as a result).

The bottom line is that, while you never want to be obsessed and fearful of risk, you should always, always, always have a plan to deal with losses as soon as you buy a stock--that way you'll never be in the position of wondering what to do with a big loser.

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As for my stock idea ... I'll stick with MAKO Surgical (MAKO).  It's a thinner stock, so it can be very jumpy. But its new story and stock action reminds me a lot of Yahoo (YHOO) back in 1998--that is, both had huge upmoves, then collapsed during the market's initial selloff, but then both actually rallied to new highs in the weeks ahead before one final shakeout.

Now, let me get one thing straight; I do not expect MAKO to do anything close to what YHOO did back during the Internet bubble. But the action is similar (both the stocks and the market environments), and MAKO's unique story--its RIO systems are making knee and, eventually, hip resurfacing and replacements more precise and less invasive--tells me it could have a great upmove ... if the market can really get going for a couple of months. I think shares are buyable on any weakness, with a stop around 31 or 32.

If you buy, keep it light, and of course, keep your stops in place!

All the best,

Mike Cintolo
Editor of Cabot Market Letter

Editor's Note:  Some investors can make good money in bull markets, and some are good at avoiding damage in bear markets. But to have great returns, you need to do both ... like Mike Cintolo (VP of Investments for Cabot) has done as editor of the Cabot Market Letter. Since he took over at the start of 2007, Mike has outperformed the S&P 500 by 14.2% annually thanks to top-notch stock picking and market timing. To benefit from Mike's advice during these challenging times--and to know when and what to jump on when the bulls re-take control--be sure to give Cabot Market Letter a try today.

Michael Cintolo can be found on Google Plus.

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