3 Steps To Winning In The New Bull Market

Includes: CAT
by: John Tobey, CFA

Picture of three step chart, risingThe "easy" money 3-year bull market is ending, but a new one is beginning. The previous, extended period of rising stock prices was built on improving fundamentals. The 2010 and 2011 mega-fear periods helped keep worry alive, allowing stock investors to acquire and hold attractively priced stocks.

However, the shift to normality is upon us. The steady flow of obviously good economic news that began in late 2011 combined with the stock market's full recovery from the summer slump has alleviated worry and rebuilt investor interest. The good news is that the increased buying has compounded unrealized gains. The bad news is that we should not expect to earn those wonderful returns by continuing to hold leading companies - that approach has been rewarded.

Replacing that bull market is a new one, filled with opportunity, but requiring a different approach. Here are the 3 steps I believe are necessary to win in the coming bull market.

Note: To some (many? most?) readers, my suggestions below will appear questionable (inappropriate? crazy?). Perhaps it would help to know that my 40+ years of investing are filled with similar "crazy" steps that produced gains or avoided losses. At the heart is contrarian investing: Attempting to identify overwrought and underappreciated areas, then acting accordingly. Doing so correctly is the route to superior returns. Below are the steps I am currently taking.

Get ready: Sell those past holdings and book the gains

I previously wrote here that our long-held positions could be viewed as a source of cash as we find new opportunities. Now, however, I believe it is better to sell and raise cash.

The main reason is that many (too many) large, leading companies look to be on the verge of a breakout, yet continue to linger at their price levels. Caterpillar's (NYSE:CAT) stock chart is similar to many others:

Stock chart for Caterpillar

(Stock chart courtesy of StockCharts.com)

Could these breakouts occur? Yes, but it would take massive buying to propel so many at once. (I am not talking about a quick burst based on short covering and limit order buys, but a true rise to new levels.) Moreover, there is no bargain-buying motive because valuations, while acceptable, are less attractive than last summer. So, can we count on enthusiasm to create the buying wave? No. While it may happen, there is a reasonable risk that it won't. And when stocks cannot go up, they tend to "fall to make room on the upside."

There is another reason for selling and booking the gains. Unlike managing a stock mutual fund, we investors are free to alter our allocation to stocks. Periodically, especially after a strategy has been successful (or not), it pays to cash out. Doing so can clear the mind and allow us to better pursue the next strategy.

A warning: Don't look back. Those stocks you just sold could go up - in fact, they probably will to some extent (it is a bull market, after all). But, like burning the bridge, selling forces us to look forward.

Get set: Develop your new strategy

While we are not entering a purely speculative market yet, a greater focus on risk will likely produce the better returns. Think back to the post-internet bubble markets in which we searched for special opportunities.

Expect more portfolio turnover and short-term gains. (In anticipation, I just changed my trading description on Seeking Alpha from "infrequent" to "monthly.")

Investor behavior analysis is important, and stock charts will be more useful during this period. They can help substantiate opportunities and identify buy and sell points.

"Stocks" include specialty funds (e.g., exchange-traded funds and closed-end funds) that can be used for particular strategies.

Go: Invest as opportunities present themselves

In the period we've just been through, we constructed and managed a diversified portfolio. Now, however, our strategy can be viewed as a diverse collection of special opportunities. Therefore, we shouldn't aim to get invested quickly or feel the need to be fully invested or diversified. Rather, we need to take our time and put our money to work only when opportunities arise.

For that reason, we need to view cash as a reserve awaiting the right opportunity, not as a non-earning asset. And we need to be happy to rebuild that reserve when making a sale.

The bottom line

The past three years have provided an exceptional period in which we could own the best U.S. company stocks and profit handsomely.

Now, however, recognized economic improvements and reduced investor worry have taken those stock prices up to more normal levels. Therefore, in order to achieve superior returns from here, I believe it is time to sell those positions, move on to a new strategy of finding special opportunities, and invest in them one by one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Positions held: U.S. stocks and U.S. stock funds, although a number of positions (including CAT) have been sold for the reasons above