3 Ways to Stay Safe in this Market

Is this a “normal” market?

GM is bankrupt. Unemployment is rising every month. Oil prices are up 90% in six months. And the market goes up.

Does it make any sense at all?

Well, it should.

A few weeks ago we looked at the three stages of a bear market rally. And right now, it looks like we are squarely in the middle of the third and final stage. As we noted a few weeks ago when we analyzed the greatest bear market rally ever:

Stage 3 [of a bear market rally] is when we see a lot more money come in. This is when the big money – mutual funds, institutional investors, etc. – start buying into the market and it appears all is well.

Right now, although nothing is too well fundamentally (housing, unemployment, etc.), a lot of things appear to be well.

We’ve entered a period of relative calm. The major stock market indices have slipped into low gear. The big money managers are also willing to get their toes wet in the markets as well.

Also, everyone is jumping on board to sound the “all clear” signal. For instance, a recent Forbes headline proclaimed, “The Recession is Over.” Even President Obama feels we’re nearing the edge of the woods too. Earlier this week at a fundraising affair, he said in reference to the economy, “It’s safe to say we have stepped back from the brink.”

A growing sense of false confidence created by the rally is one of the classic signs of the third stage. And now that we’re here, I continue to encourage everyone to buy in, but stay safe as well. Here are a few ways to do both.

Go Against the Grain

The last three months have been something really special. The markets are still up about 40% from the “world is coming to an end” lows, and different sectors heat up for a while, only to cool off a few months later.

It’s all part of “the power of thesis.” A thesis is basically an idea of one sector which will benefit from an external event or trend. As we’ve looked at a few times before in the past months, each new thesis doesn’t last long. In most cases they don’t last more than a few months. But it can be quite profitable if you watch closely.

For instance, a few months ago we talked about how for-profit education stocks were a bit too popular. Shares of Apollo Group (APOL), the industry leader of the industry, were up 50% from their credit crunch lows and everyone was jumping on board.

The thesis, as they usually are, was simple. The basic rationale was that for-profit education will benefit from layoffs and increased government spending on advanced education.

Makes sense, right?

Well, it did. Then the stocks started going up. Every company in the sector was releasing solid earnings and revenue growth. The good news and upward moves just reinforced the thesis. Wall Street analysts were upgrading the stocks and increasing their earnings estimates.

It was a great run across the entire sector and great expectations quickly followed.

As leading value investor Seth Klarman said:

“…most investors tend to project near-term trends—both favorable and adverse—indefinitely into the future.”

And that’s exactly what everyone was doing. They were expecting the good times to last well into the future. Once reality set in though, stocks go right back down to where they were. As I write, Apollo’s shares are off more than 30% since our warning.

The problem with market theses is they just don’t last. We see it time and time again. We watched it in many different sectors. Now, we’re witness another thesis – buy auto parts suppliers because they will do well as Detroit goes bust – wind down.

That’s why, despite the incredible momentum created in many different sectors according to the prevailing thesis, it’s still best to go against the grain.

Of course, avoiding and at times going against the prevailing thesis isn’t the only relative safe bets out there. There’s a few more. One is an old strategy which allowed the largest company in the world to thrive for nearly two decades.

Follow the Leader

Jack Welch is one of the most successful business leaders of the 20th century. His aggressive management style was loved by some and hated by others. As the leader of GE’s turnaround in the 80’s and subsequent growth in the 90’s, it’s tough to deny he knew what he was doing when it comes to business.

One of Welch’s core strategies was something he called, “Number 1, Number 2.” This strategy called for a division of GE to be one of the top two companies in a sector or industry. If the division of GE wasn’t a leader, it was closed down or soled.

Welch put it best when he said:

“When you’re number four or five in a market, when number one sneezes, you get pneumonia. When you’re number one, you control your destiny. The number fours keep merging; they have difficult times.”

That principle was key to GE’s turnaround in the 80’s and can actually be used in the markets as well.

For instance, it’s no secret we’re in difficult times. We’re in a full blown recession. A recession is a natural and healthy thing. It takes industries which are too big and shrinks them (as long as they’re not bailed out, that is). The lack of jobs in one sector forces people to go to where they are needed.

The best in the industry survive while the number 3’s, 4’s, 5’s and beyond eventually have no place at all. It’s the same for employees. When a company downsizes they don’t normally get rid of their best, most productive workers.

So for your “safe money,” I recommend sticking to the world’s leading companies. They will be there during ups and downs. They’ll be able to make their dividend payments. They’ll actually be in position to expand market share during tough times.

Although every case is different, the number 1’s and number 2’s in most industries are always survivors.

Trailing Stop Losses

Finally, there is one way to ensure you can go along for the ride and don’t get wiped out – trailing stop losses.

I’ve been using these on and off for about a decade. The growth and development of online discount brokerages has made them available to everyone.

As I reviewed my portfolio this evening, I’ll tell you that I have trailing stop losses in place on nearly three fourths of my open positions (the rest are highly speculative, volatile stocks which I go in with an understanding that the downside risk is 100% – of course the upside potential is much, much higher).

Trailing stop losses take all the emotion out of a trade. They automatically sell a stock when it goes against you. They limit risk without limiting upside potential. I say I used them “off and on” over the years. But in a time like this, when the end of the rally could be tomorrow or six months from now (the latter being more likely), they’re definitely “on.”

Stick to the Plan

In times like these, I freely admit I have no crystal ball. I don’t know what’s going to happen next. Sure, there are there’s still 3.7 trillion left in money market accounts which hasn’t gotten sucked into the markets yet. But there’s also a lot of bad news to come. Exotic mortgage resets, California bankruptcy, or the looming pension debacle could put an end to any rally.

But I try not to get too concerned in the day-to-day stuff because I have all the strategies above incorporated into my plan.

As long time readers of the Prosperity Dispatch know, before I ever make a move in the markets or recommend action, I always have a plan. It’s always written down. And I always stick to it. It takes all the emotions out of decision making and looking back, it saved me far more money.

At this point in the rally, it’s quite easy to come out a fool or a genius – either way you bet. As a result, I’m still betting for a rise in a few sectors. But, of course, I’m not going to take any excessively large losses if the market takes another dive.

It is times like these I remember the advice of Bernard Baruch, one of the legendary stock market speculators. He once pointed out:

“The main purpose of the stock market is to make fools of as many men as possible.”

The way these tried and true strategies work, we won’t be looking like fools either way the market goes from here.

By Andrew Mickey

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