Three Reasons to Be Cautious Today

 

More on the Pareto Principle

Three Reasons to Be Cautious Today

The Rewards of Value Investing

In last week's column, a reader introduced the topic of the Pareto Principle, named for the economist Vilfredo Federico Damaso Pareto, who had observed in 1906 that 20% of the population owned 80% of the property in Italy.

Over time, Pareto came to believe that the 80-20 distribution applied to many other economic realms, as well, and we still refer to it today.

I wrote,

"More relevant to your own interests, we like to say that 80% of your profits come from 20% of your stocks, and your job is to identify those winners as quickly as possible, so you can ditch the losers and buy more of the winners, boosting your profits even more."

Which caused one reader to write,

Tim,

Concerning the last paragraph of the Pareto Principle, I have been thinking about that a lot lately. Given that 80% of the profit is from 20% of the stocks, why isn't Cabot recommending such an investing/trading strategy, say in the Cabot Market Letter and the China Report? I guess as a publisher, the obvious reason is it's too much risk ... but from an individual point of view, let me throw in my thoughts.

Let's say I hold 10 stocks, and after a while, I can see that 2 of the stocks are doing very well; at the moment, I would say VIPS & BITA are performing very well. My thought is, why don't I sell 4 of the other 8 stocks and use the cash to buy more of the 2 stocks that are doing well? To cut down on risk, I will keep the other 4 stocks as is. To really cut down on risk, once I start seeing that the 2 stocks that are doing well start to sell off on high volume, say for two straight days, I will sell the 2 stocks completely on the 3rd day - this way, I'll still be able to lock in the high profits that I have gained. After that, I'll repeat the process, hopefully, over a period of time, another 2 stocks would start showing that that are doing well. Of course, this is assuming that we are still in the bull market.

Your thoughts?

Thanks, Roderick Y. Walnut, California

I already answered Roderick but I'd like to amplify my answer here.

First, most people simply cannot follow or tolerate such a program of concentrated investing. On the way up it's great fun, but all it takes is one sharp market correction that knocks down a couple of hot stocks to send most people running to safety-after which they refuse to get back on that horse.

My father was one investor who could and did embrace concentration. When he was editor of Cabot Market Letter, he'd frequently tell readers to average up in their best performers, because that was what he was doing himself.

Sometimes, he'd have half his portfolio in one high-flying stock! (Of course, he'd build that position over time, buying more only at higher prices.)

Another big risk-taker of years past was Al Frank, who consistently ran a fully margined, fully invested portfolio in his newsletter, the Prudent Speculator (Al passed away in 2002). In prolonged bear markets, the results of that leverage were very painful, but given that the market's long-term trend is up, and that Al always benefitted from being fully margined in every following bull market, it was smart.

But most people just can't tolerate the insecurity of such high-risk, high-volatility portfolios. Most people need more stability in their portfolios.

So today, Cabot publishes advice that the majority of readers can follow and stay "comfortable." It may not always be the most profitable way of investing, but it's the way most people can follow.

As to Roderick's proposed system, it sounds a little more short-term than I can endorse-I can imagine a stock falling for three days and then resuming its uptrend on the fourth. But if it fits your personality, I say give it a shot!

---

Three Reasons to Be Cautious Today

The current bull market has lasted either 18 months (since November 2012) or 64 months (since March 2009), depending on how and what you measure. Either way, it's getting long in the tooth-which means that somewhere ahead lies a correction or bear market.

And if you can avoid losing money in that correction/bear market (usually by holding cash), you can preserve more of your profits from the current bull market, and thus be in fine shape for the beginning of the next bull market.

But how do you determine when a bull turns to bear?

Unfortunately, there are no perfect market timing systems. The market likes to keep us off balance by acting a bit differently in every market cycle.

But there are useful signs and tools (history doesn't repeat, but it rhymes), and a number of them are speaking to me today, warning that the correction/bear market may have already started.

1. Sentiment Indicators

It's a fact that investors are most bullish/optimistic at market tops and most bearish/pessimistic at market bottoms. In other words, investors' emotions are their worst enemies.

In our interactions with customers in recent months, we've noticed a growing diminishment of fear and a growing willingness to embrace risk. The letter above from Roderick is just one example.

2. Fundamental Indicators

Remember all the worry about growing unemployment last year? It's gone. Now we have second-quarter growth of 4% and job growth has been consistently good this year, and the main domestic worry for economists is that the Fed will start tightening. All the big problems now are overseas. Bull markets climb a wall of worry, and when the worry disappears, so does the bull market.

3. Technical Indicators

Cabot's Two-Second Indicator monitors the number of stocks hitting new lows on the NYSE every day to detect divergences-which typically precede major market tops. The most dangerous condition comes when the number of new lows exceeds 40 day after day while the major indexes are hitting new highs.

The selloff that began July 25 saw the number of new lows exceed 40 on the very first day after the market peak (or sub-peak, depending on the index). That qualifies as dangerous (but not most dangerous).

Also flashing a danger signal are the Cabot Tides, our intermediate-term trend-following timing system, which turned negative last Thursday.

Put it all together, and what do you get?

A strong probability that, at the very least, the uptrend of the past few months is over, and possibly that the overall bull market is over, at least for the broad market.

That doesn't mean that the major indexes can't hit new highs; they frequently do at the tail end of bull markets, even as the majority of stocks are going down.

But it does mean that it will be harder to make money, and easier to lose money.

Thus-increased caution is now warranted, which means keeping close tabs on your poorest performers, as well as selling stocks that aren't doing what you paid them to.

What About New Buying?

And when it comes to new buying (perhaps you're underinvested, or you want to reinvest assets from a recent sale), it's more important than ever to ensure that risk is low.

And the best way to do that is to pick a value stock!

So where do I turn when I want a value stock?

I turn to Roy Ward, analyst of Cabot Benjamin Graham Value Investor.

Roy has been toiling diligently for Cabot for more than 11 years now, guiding thousands of satisfied readers to low-risk, high-probability stocks.

And it's worked out quite well.

In fact, Roy's August issue was published just last week, and it included this chart...

... which shows that over the past 11 years, Roy's Value Model has gained 242%, while the Dow has gained just 110% and the S&P 500 has gained only 76%.

In short, Roy's system works, not least because it's a diversified investing system that most investors can follow.

I will admit that value investing is not particularly exciting. Many of Roy's stocks never make headline news. But they do appreciate over time, and in the long run, that's what most investors want (and need).

Back on July 23, for example, Roy sent this update to his readers about Gildan, a Canadian clothing company whose leading revenue stream is the very unexciting business of making blank t-shirts. Gildan sells this "printwear" in bulk to companies that print logos and other promotional content on them.

"Gildan Activewear (GIL 60.58) reached its Minimum Sell Price of 60.40 yesterday, July 22. GIL was first recommended in the Special Features Model using the Undervalued Canadian Stocks analysis in the October 2012 Special Feature Edition at 32.17. GIL has gained 87.8% during the past 21 months compared to a much smaller gain of 38.8% for the Standard & Poor's 500 Index during the same time period. GIL's current P/E is 21.3 compared to its 10-year average P/E of 15.3. GIL is overvalued and should be sold."

That's it. Not very exciting, but devastatingly effective.

If that sounds like the kind of system that would work for you, Roy would be happy to take you under his wing.

You can learn more here.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Chief Analyst, Cabot Stock of the Month
Publisher, Cabot Wealth Advisory


Timothy Lutts can be found on Google Plus.

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