Picking tops and bottoms is dangerous business, but so is watching all the profits in your 401(k) plan from the last several years dissolve before your eyes.
Many long-term, traditional "buy and hold" stock investors have gotten burned over the last decade, and with current pricing on the S&P 500 near the 2000 and 2007 highs, it might be time to protect profits.
Investors are well aware that the bursting of the dot.com bubble triggered the 2001-2002 bear market, and the global financial crisis ushered in another vicious bear in 2008. However, there are simple technical tools that long-term stock investors can utilize to protect profits -- these include a 200-day moving average and basic trendlines. Taking a look at the current market landscape, it might be time to consider implementing these tools.
Why? Let's take a look at the monthly chart for the S&P 500. Simply put, you can see the S&P 500 has been locked within a large sideways range for the past 10 years. Within that range, we've experienced two bear markets and two bull markets. The latest bull market is nearing resistance from the October 2007 high.
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Unless you think the U.S. equity market is going to smash through decade-long resistance, it could be a good time to look at booking at least partial profits on longer-term investment plays.
Fundamentally, the fourth quarter of 2012 ushers in a bevy of challenges for the U.S. economy and the stock market, notably the widely discussed "fiscal cliff," which involves automatic spending cuts and tax increases set to go into motion on January 1, 2013. The Congressional Budget Office (CBO) has estimated that the fiscal cliff policies currently slated for the New Year will reduce the federal budget deficit by nearly 4% of total GDP in fiscal year 2013. What does that mean? Many economists say if the current fiscal cliff laws are allowed to go into effect, it almost ensures the U.S. will retreat back into recession in 2013.
The stock market, after all, tends to be a leading indicator (not a lagging one), and with expectations for slower U.S. growth in 2013, this will likely be priced into the stock market sooner rather than later.
Many political observers hope that policymakers will address and derail the fiscal cliff in the lame duck session of Congress after the U.S. presidential election. While the full negative impact of the fiscal cliff may not come to pass, the stock market is unlikely to be patient. And, given that the S&P is near decade-long highs, the bulls simply could be running out of steam. There is only so much QE-induced rally that can occur. After a time, the market needs actual growth performance to continue the bull.
For those interested in protecting profits, the simple 200-day moving average seen below in Figure 2 can be a useful tool. The 200-day moving average is considered by many to be a proxy for the longer-term trend. If the S&P 500 is above the 200-day moving average, then the longer-term trend is bullish. If the S&P 500 is below the 200-day moving average, then the longer-term trend is bearish.
For most of 2012, the S&P 500 has traded above the 200-day moving average. To avoid whipsaw like at the June lows, investors could use a filter like five consecutive settlements below the 200-day moving average as a trigger to book profits or partial profits. Trendlines can be used in a similar fashion. A bullish or rising trendline is drawn on Figure 1. When trendlines are broken, traditional analysis suggests the trend is broken.
While it may be a cliché, for longer-term investors it is true -- the trend is your friend. With some proclaiming that buy and hold investing is dead, it is worth taking the time to learn the basics of trend analysis and some simple tools that can keep you on the right side of the profits column.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.