Gentlemen, Start Your Buy Lists (Ladies Too)

Includes: DIA, SPY
by: DAG Investments

"[There are] three Sentiment Stages of a Secular Bull Market:

1 = Disbelief / Blue Chips [aka, large-caps]

2 = Belief / Secondary Stocks [aka, mid & small-caps]

3 = Complacency/Speculative stocks [aka, small & micro-caps]

This Secular Bull Market is in its second sentiment stage -- small and mid-cap stock leadership is a sign of belief and trust in this market."

-- Ralph Acampora, CMT

Before I explain why I used that quote and get into the subject matter of the article, first, I must apologize to female readers for the headline. I was trying to be clever and it just didn't sound right any other, more inclusive, way that I tried to word it. I also have to clarify that I didn't really mean "start your buy lists". In my view, we all should've done that long ago and, in fact, should have a buy list pending at all times. So, what I'm really saying is that, in my view, there are likely to be several good opportunities to start executing our buy lists between now and the end of the year. That's just not a very catchy headline.

As I mention every chance I get (and have discussed in my Instablog), one of my strongest opinions about stocks is that when to buy is just as important as what to buy. From recent conversations with other Seeking Alpha readers, I realized that it might be helpful to some if I further explain my opinions regarding how to actually act on the idea behind that statement. To that end, I'll discuss a few specific topics related to putting together a buy list, as well as when to use it.

That's where the quote at the top of the page from Ralph Acampora, CMT comes in. In a moment, I'll discuss more specifically why I used the quote and how extremely relevant I think it is to the issue at hand, but I think it most appropriate to first mention who Mr. Acampora is.

Ralph Acampora, CMT, is Senior Managing Director at Altaira Wealth Management and a senior member of the faculty at the New York Institute of Finance. Mr. Acampora is often referred to as "the Godfather of technical analysis". That's a pretty long series of titles so, respectfully, I'll just refer to him as a market technician. Most important, he's exactly right about the market far more often than he's partially right. No, that sentence wasn't a mistake … I wrote it exactly the way I intended to.

A bit later, I'll also discuss why I think it's very important for every investor to include a good technician, along with a couple other specific professionals, among their most valued investment resources. For now, I'll focus more on how the "stages" of market cycles are important to making a good buy list, before I get into knowing when to use the list.

So, back to Mr. Acampora's quote. In case this isn't obvious, I think that he's exactly right (again), although some others argue that we're actually in a cyclical bull market within a secular bear market. I don't purport to know how this will ultimately play out so I focus on what I know -- what has actually been happening. For example, this Wall Street Journal article discusses the fact that the Russell 2000 small-cap index recently broke out to new all-time highs, and suggests that means the S&P 500 will break out soon too. I happen to agree.

Related to focusing on what we actually know, I think the following quote from someone much smarter than me says it better than I ever could. The quote is from a piece entitled "Portfolio Selection" by Harry Markowitz -- Nobel Prize co-recipient for Modern Portfolio Theory and the Capital Asset Pricing Model -- and was published in The Journal of Finance in 1952:

"The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of the portfolio.

At least to me, that sounds very much like disbelief transitioning to belief as a result of observation and experience; and belief being followed by speculation about what the future will hold; which is just my paraphrasing of the market stages and the above quote.

In fact, that's exactly what I've observed and experienced over the past few years and it's been very profitable, which is why I'm writing about these topics -- in hopes that being more conscious of these predictable stages/transitions will help other investors as it has helped me.

For example, because Mr. Acampora's commentary is among my primary investing resources and I had read similar comments from him before I came across the specific quote above; and because the other specialists I rely on most for general market guidance have been expressing similar opinions for the past few years (that we were likely entering a secular bull market); I was lucky enough to take advantage of stage one ("Disbelief / Blue Chips"). In other words, up until this year, there were still very many large-cap (or otherwise relatively safe) stocks at significantly undervalued levels. So, I spent most of 2010-2012 buying stocks like: Blackstone (NYSE:BX), Halliburton (NYSE:HAL), Kroger (NYSE:KR), Trinity Industries (NYSE:TRN), Williams Companies (NYSE:WMB), etc. I'm not suggesting buying those stocks even though I still own them. I'm just offering examples, rather than ask you to take my word for it. I may write articles later to recommend them.

Similarly, thanks to the guidance of the individuals I rely upon for general market guidance, I expected the small-cap breakout scenario mentioned above as part of the typical cycle. For that reason, I've focused on small and mid-cap stocks most of this year, even though a larger portion of my portfolio is actually large-caps. I'm continuing in that direction since I believe small and mid-cap outperformance will continue for a while. So, I've recently written a few articles about some of the small and mid-cap companies that I like, and I have more on the way.

My personal belief is that the reason secular bull markets progress in the three stages Mr. Acampora specified is investor psychology. In other words, when investors are less confident during stage one, we buy "safe" large-caps. As our confidence builds and safe large-caps become fairly valued, we buy mid and small-caps. Then, there comes a time when the only place we can find any value left is speculatives.

By the way, when I mention "speculatives", I am not talking about penny stocks. I don't do windows and I don't do penny stocks. Well, actually, I've been known to do windows, but only my own so you get my point. Anyway, when I refer to speculatives, I'm talking about real profit-making companies with stocks that have been beaten down for some reason and/or the company is in transition. Such stocks are often in the ~$5-$10 range, or even a little lower for those with particularly strong stomachs. The most risk averse investors consider any stock below $5, or even $10, a penny stock; and while I understand and respect that we all have different risk tolerances, I disagree that a certain cut-off price alone automatically makes a stock inherently bad.

The reason I disagree is that I have proven otherwise to myself, not once or twice, but over and over and over again. Examples that, within six months to three years, have earned for me share price doubles, triples and even four or five baggers include: Consolidated Water (NASDAQ:CWCO), Media General (NYSE:MEG), Mueller Water Products (NYSE:MWA) and Xerium Technologies (NYSE:XRM). To be clear, this is not a recommendation to buy any of those stocks. I do still own two of them, but again, I'm just offering examples. I may write articles about the ones I would still buy at current prices.

The reason I mention speculatives at all is that, if you believe Mr. Acampora, as I do, speculatives will be the next area of opportunity. If that is the case, it obviously makes most sense to consider such stocks for our buy lists before the third stage begins. For that reason, I recently wrote an article about a small-cap that has an element of speculation to the story and I'll probably write about other speculatives soon.

In any case, I mention my experiences with the three stages because I believe that, in addition to the finding specific stocks that are right for a portfolio; an integral part of developing a buy list, thus a strong portfolio, is focusing on the right kinds of stocks at the right times.

Now, I'll talk a little about "the right times" part of that last statement. As is already evident, I consider following the commentary of a good technician like Mr. Acampora to be an important part of the equation. However, I also want to stress that I don't believe in basing decisions on technical analysis alone. I consider fundamental and macro-economic analysis equally, if not more, important than technical analysis. In fact, I consider views from market strategists most important. So, the main reason I started out talking about technicians is because I thought it particularly important to first share Mr. Acampora's quote about the market stages. With that said, I also think investors should regularly follow commentary from a good strategist or two, and an economist.

First, at risk of boring the more experienced investors, I have to make sure the distinction between "strategist" and "analyst" is clear. While they are often former analysts, strategists advise us on the market as a whole, rather than individual companies/stocks. In other words, a good strategist is important because his/her fundamental analyses combine with a technician's analyses to help us decide when to start raising cash in preparation to buy stocks, when to buy stocks, and when to sell stocks. Strategists often have titles like Chief Investment Officer (CIO), but titles vary greatly so the important things are the person's expertise, focus and track record. Many strategists publish reports on a weekly or even daily basis so the first thing I do every morning is read their reports.

The point is that I highly recommend finding a couple good market strategists to follow -- ones with strong and long track records of being right far more often than they're only partially right. I'll not get into specifically who I rely on most for that purpose because, by doing so, I would effectively be posting on the internet exactly where each of my financial accounts are held. And, unfortunately, it is indeed possible to aggregate enough personal information about a person from the internet to cause harm, so that wouldn't be wise. In any case, as I just alluded to, my personal belief is that, if I have enough faith in a particular firm to put money there, part of the decision of developing that level of faith should have been how good their strategist is.

It's also important to follow commentary from a good economist -- a big-picture guy (or gal). However, it's usually not necessary to read economists' reports frequently since economies don't really change much daily or weekly. So, economist's views can be checked in on periodically and combined with those of strategists and technicians to make our final decisions as to whether to buy stocks at all or take a more defensive stance. What I mean is that, as much faith as I have in the individuals I follow, I consider it always my responsibility to make my own final judgments about what to do with my money. I always have to make the final call that I think is right -- no one else can ever do that for me and it would be my mistake to let them, not theirs.

There's one last component to the reason I believe "there are likely to be several good opportunities to start executing our buy lists between now and the end of the year". Much like short-term traders tend to settle up trades at the end of each week (or day) to avoid going into weekends with loose ends when there could potentially be market moving news; many longer-term investors tend to do more selling toward the end of each year for a number of reasons. Those reasons include [1] political risks since various types of elections and other important political votes tend to take place toward year end, [2] realizing capital gains losses for tax-loss benefits, [3] profit taking for holiday and other year-end expenses and [4] simple rebalancing to bring position weightings back to desired levels.

I'll wrap up with my favorite investing quote of all time, and my take …

"The trouble with you, Byron [Byron Wein - Morgan Stanley], is that you go to work every day and think you should do something. I don't. I only go to work on the days that make sense to go to work. And I really do something on that day. But you go to work and you do something every day and you don't realize when it's a special day."

-- George Soros

I immediately loved that quote when I first saw it because I identified with what I believe Mr. Soros was getting at since it's exactly what I do -- work relentlessly on the days that make sense to do so. In other words, there are certain days that I'm entirely and intensely focused on buying and/or selling everything that's not tied down (then looking for some scissors to cut loose what is tied down). However, there are also days that the market and most all of my holdings are trading sideways. On those latter days, I could work hard all day and not accomplish a thing. So, I try to make myself go to the beach or something -- I've gotten some good stock ideas at the beach, by the way. Again, the main point is that when to buy is just as important as what to buy.

Thanks for reading. I'll try to answer any questions you might have in the comments section and I always appreciate feedback, even if it's just to let me know whether or not you found my ramblings useful.

I've thrown in the chart below just because I think it's a really interesting chart that relates to some of the points I've tried to make, but I couldn't figure out an appropriate place to put it within the text.

(Click to enlarge)

Source: Charles Schwab

Disclosure: I am long BX, CWCO, HAL, KR, MWA, TRN, WMB. 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.