How To Trade The Swings Between Irrational Pessimism And Exuberance

 |  Includes: SPY, VXX
by: BubbleBustInvesting

Emotions have always been an important factor behind market volatility, especially when markets trade on headline news, and investor emotions swing between irrational pessimism and irrational exuberance. Just take a look at the market performance in the last three months: Three weeks ago, the S&P500 (NYSEARCA:SPY) headed for the 1000-mark. Last week the S&P500 was headed for 1300, while this week it is heading towards the 1200-mark. What should the intelligent investor do?

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Focus on the economic fundamentals, as shaped by two trends: The prospect of a worldwide recession that will eventually touch China, and the prospect of continuing, even worsening European sovereign debt issues. However, the problem is that the two trends create crosscurrents that make investing in certain classes of assets tricky. The prospect of a recession, for instance, is bearish for precious metals, while the prospect of worsening sovereign debt woes is bullish. This means that investors should pursue a subtle trading strategy.

Here are several trading ideas they may want to consider:

1. Stay away from the stocks of large financial stocks like Goldman Sachs (NYSE:GS), Citigroup (C), Bank of America (BAC), Morgan Stanley (MS), and JP Morgan (JPM) that may be negatively affected by a worsening in the European debt crisis.

2. Sell high-flying cyclical stocks. A double-dip recession is certainly not good news for cyclical stocks like Caterpillar (CAT), Ford (F), General Motors (GM), Toyota Motor Company(TM), and Honda Motor Company (HMC); and it is certainly bad news for high-fliers in the materials and energy space like Walter Energy (WLT) that missed on second quarter revenues by a great margin, and is up 400 percent since 2009. Cliffs Natural Resources (CLF) is up 300 percent; and energy companies included in Oil Service Holders (OIH).

3. Avoid Precious Metals. Precious metals are caught at the crosscurrents of a bearish trend (the recession), and a bullish trend (the sovereign debt crisis), that’s why it is best to avoid them, especially after their big run up. Ishares silver trust (SLV) is up 300 percent since early 2009; SPDR Gold Shares (GLD) is up 110 percent; and Freeport-McMoRan Copper and Gold (FCX) soared 200 percent. But the commodity rally may be over. Monetary policy is no longer ultra-accommodating, and some have raised rates (China, Brazil, and India). The dollar is stabilizing, the world economy is slowing, and inflationary expectations are tapering off.

4. Avoid momentum stocks. Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind-- at times when money is cheap. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Cisco Systems (CSCO), Ciena Corp (CIEN), JDS Uniphase Corp (JDSU), Corning, Inc. and Ariba Inc. (ARBA). Now the theme is social media and web-based companies, like Netflix, Inc. (NFLX), Open Table Inc. (OPEN), and LinkedIn Corp (LNKD). Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away, especially for investors who got in at the top.

5. Buy non-cyclical stocks. These stocks fare better during a recession like big pharma stocks - Pfizer (PFE), Bristol Mayer’s Squibb (BMY), Abbott Laboratories (ABT), Eli Lilly (LLY) and Merck (MRK) – that enjoy hefty profit margins, ranging from 19% to 32%; and pay hefty dividends, ranging from 3.80% to 5.5%, compared to 1.88% for S&P 500 stocks.

6. Buy bellwether stocks like Oracle (ORCL), Intel (INTC), Apple (AAPL), Google (GOOG), and Microsoft (MSFT) with dominant market positions.

7. Stay away from U.S. Treasuries and Treasury ETFs like AGG, BND, LAG, and TLT. Though U.S. Treasuries are the first investment to come to mind when the economy heads into recession, this time yields are already near record low levels, notwithstanding the impending downgrades. So any gains from these levels will be limited.

8. Buy protection. Short or buy puts on SPDR S&P 500 (SPY). The problem, however, is that S&P500 had a big correction already. So investors may want to average into this trade rather than going outright into a major position; and they may want to apply the same strategy with iPath S&P 500 VIX Short-Term Futures ETN (VXX).

Disclosure: I am long C, JPM, PFE, BMY, BAC, F.

Additional disclosure: Short on GS,SLV,WLT,CLF,INTC