After three months of going up and up, the market has pulled back a bit and seems to be trading sideways in April. Couple of positive days followed by couple of negative days. Rinse and Repeat. This is exactly what happened for most part of 2011, especially until December.
The Dow Jones Industrial Average (DJI) was up on Wednesday and Thursday of this week after 5 consecutive down days. The positive run was aided by Alcoa (AA) earnings and QE hopes. However, China's GDP came below the estimated 8.5%, coming in at 8.1 % Thursday evening. This has already jolted the stock futures and is very likely to hit the entire market. Names that are dependent on China like some material stocks better watch out.
What's An Investor/Trader To Do: If the market continues to behave this way, we believe investors will do well by following the 4 points mentioned below
- Investing In Dividend Paying Stable Names: This comes of almost as a no-brainer for all market conditions. Investing in names like Philip Morris (PM), Coca-Cola (KO), McDonald's (MCD) not only provides low volatility but also stable dividends. As long term investors would attest, reinvested dividends act as bear market protectors and will skyrocket the long term returns when the market gets into a bull mode again. Reinvesting dividends is much more important during bad times than good times as it leads to more share accumulation.
- Investing In Depressed Leaders: While there are no good names that come to our mind in this category right now (because of the run up), obvious examples from 2011 are companies like Apple (AAPL), Google (GOOG) and Baidu (BIDU), which traded at very low valuations compared to their averages. It might sound like hindsight bias commenting about these names in 2012. But when a best of breed stock is trading at a discount to its historical valuation and there is nothing wrong with the company in specific, it's a low risk- high reward trade.
- Trading Cyclical Leaders: Cyclical stocks like Freeport-McMoRan Copper & Gold (FCX), Caterpillar Inc (CAT) and Southern Copper Corp (SCCO) have moved sharply up and down since 2011. If one observes these trading ranges carefully and picks them up at the low end of the range, easy profits can be made. SCCO for example has pretty much traded between $30 and $33 for a long time. Any speculation on good news about China such as on Thursday pushes the stock up a good 5%. And on days where China disappoints, the stock loses ground easily. This has been an exploitable pattern since 2011 in many stocks and we have made good money on SCCO in particular. The good thing about "trading" companies like SCCO, FCX, CAT is they all are strong names and also pay dividends. So even if your trading timing is not spot on, these can be winners in the medium term.
- Trading Bear Shares: Direxion Bear Shares like Daily Small Cap Bear (TZA) and Daily Financial Bear (FAZ) have drastically underperformed so far in 2012 and for obvious reasons. But with things turning volatile and almost bearish, now might be a good time to go long on these bear shares. The chart below shows the spike in TZA shares during the summer distress in 2011 and right now TZA trades at about 1/4th of that level. Things may not get as bad as 2011 but with the bulls and bears taking one blow at a time, one can profitably trade these bear funds by buying them on down days like Thursday (which was an up day for bulls, remember these bear funds work the opposite way) and selling them on days the overall market is in red.
Conclusion: There is no fun in a market that keeps going in just one direction and every stock picker looks like a winner. 2012 has just gotten interesting in our opinion. Choose your exposure to each of the 4 categories mentioned above based on your risk tolerance. We have left out tax and trading costs as they are very specific to the individual. Have fun trading and investing.
Disclosure: I am long AAPL, PM, KO, BIDU, GOOG, TZA.