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April 14, 2012 - 3 Strategies to Thrive in a Sideways Market - By Zacks Investment Research
By: Kevin Cook
Great portfolios are built with a flexible plan to profit in multiple environments.
When a bull market is propelling your portfolio higher, it's hard to think about what you'll do when the inevitable pullback comes. You get torn between thoughts of protecting gains and missing upside.
The solution for this confusion is to have a "Plan B" that not only expects a pause - even a correction - but profits from it. There are 3 strategies that can serve you when Mr. Market decides to go sideways.
1) Play the Swings
If you have significant gains in your stocks from a 25% to 50% bull run in the broad market, there are many things you can do instead of sell them. You could protect them with puts. You could buy puts on the given index your portfolio most closely represents from Dow blue chips to Russell small-caps.
You could also sell select names that have run the most, or partial positions. Any 50% to 100% winners in there? The idea here is that when you've reaped big rewards from a solid run in your favor, it's always a good idea to take some money off the table. Then you have cash for the dips, and restful nights sleeping on profits in the bank.
We know that markets don't run straight up indefinitely. We also need to remember that nobody can pick all the tops. So keep your best stocks and sell your weaker ones when the market confirms that it is indeed rolling over. You always run the risk that one gets away. But a clear head and cash in hand will give you focus for new opportunities.
This approach worked in 2011 when the S&P 500 formed a long stretch of failed attempts to break decisively through 1,350. I sold a lot of holdings in May because I thought the market was leaning toward a "sideways-to-lower" tack. I was two months early, but profits in hand gave me confidence to buy dips and play the swings.
2) Think Long Term and Ride It Out
Once a decline takes hold and you find you're buying stocks on the way down, you might start to wonder if you've been had by Mr. Market. This is a good time to reevaluate where the economy is at in the cycle and if a bear market is possible. Are the odds of a recession high and are stocks, especially cyclical sectors, predicting one?
In the meltdown of 2011 - driven by the US debt ceiling debacle, abysmal GDP growth and the European financial crisis - the odds of a recession grew to nearly 50% according to many economists. That coin flip probability meant you had to watch the data very closely and have a big-picture view of larger economic forces.
Two of the biggest forces I had my eye on were the most important banks in the world: the Federal Reserve and the European Central Bank [ECB]. It seemed to me that the Fed would keep doing what it was doing so well - backstopping the economy - and that the ECB would get the same religion. As long as central bankers feared a deflationary spiral enough to prevent it, then we could look at the positive economic growth factors.
China and other emerging markets have been one of the strongest forces contributing to the growth of US brands like Caterpillar, McDonalds and Apple. This megatrend was far from over, and far from being derailed just because of the Euro-debt mess.
As earnings estimates for the S&P 500 came down only gradually in the fall of 2011, I saw an incredible opportunity to buy stocks near S&P 1,100, calling it "an extreme value area." When you have a big-picture view, you retain confidence while others run in fear.
3) Buy Great Stocks on the Dips
By far the most exciting thing about a market sell-off is the chance you get to buy your favorite names "on sale." The half-dozen swings that the S&P 500 made between 1,100 and 1,200 between August and November of 2011 gave you several opportunities to buy great stocks and either trade their swings, or keep them for the long-term.
And now, the spring of 2012 has possibly given us a similar opportunity, though don't expect the volatility to be quite as severe. A market pullback is in force, with the major indexes fighting for their 50-day moving averages after a 30% rally off the lows.
What are the opportunities? First, let's establish that the bull market is still well intact because the global economy is still humming along and creating profit opportunities for all sectors of business. Second, you have to ask: "How bad-or good-could the pullback get?" As of the second week of April, the worst decline has been only 4.5% and money managers gobbled it up because so many missed their chance 10% ago.
Since the bull market is strong and stocks are the place to be, it would take a very negative catalyst to give us a 10% correction. That means it's time to assemble your buy list for the 2-6% pullbacks. Just as we set target prices for stocks based on our expectations of earnings and "full valuation," we can also identify "extreme value" levels where we always want to buy them.
As sure as the seasons change, markets will swing on emotional extremes of optimism and pessimism. If you can spot when great stocks are over-sold by irrational investors, then you can take advantage of it and have something to sell back to them at the next peak. Or you can just keep great stocks for as long as you like. Whatever your style of investing or trading, Zacks definitely has an app for that.
Good Investing, Kevin Cook
Kevin, a Senior Stock Strategist at Zacks, is a recognized authority in global markets. A former market-maker in the $4-trillion-dollar-a-day world of interbank trading, he developed the ability to track the movement of money, and trained his reflexes to take advantage of it. His Tactical Trader is one of the services that you can apply in our guaranteed program - Zacks Ultimate.