How to Invest When Stocks Keep Falling
After a bear market, money tends to sit idle in money market funds for too long. During the recovery after a bear market (that is, in the early stages of the new bull market), individual stocks are shaken. They are often broken as the market rises. Market watchers will announce that the market is up 5% year to date, but you may not see it in your own account. Although some individual stocks may be going up and down rapidly while others crash after unsuccessful attempts to rise, the overall movement of hundreds of shares is a rally. For those who don’t know how to navigate a treacherous market environment like this, ETFs (Exchange Traded Funds) provide ways to participate in the advance even though individual stocks are in a state of high turbulence.
Most of the time (in normal times), investing in individual stocks can generate much better returns than investing in a market index fund. Even when the S&P 500 is going up, it will usually have a lot of declining stocks that will offset many of the rising ones. Your individual stock picks, on the other hand, may be among the best offerings or strongest stocks in the S&P500. You may hear advisers project returns of 7-10% for the general market (which usually means the S&P500) over the next few years. That return is the net after balancing all the losers against all the winners. Select individual stocks within the S&P500 may appreciate by 30% or more over the next year (they may even move more than once from trough to peak by 30% or more during the year).
Now let’s narrow the focus a bit. Individual sectors within the market are also made up of many stocks. Even when a sector is going up, some of the stocks within that sector may not be going up. Some will be much stronger than average, and some may be declining. Some of the stocks within the sector may be rising rapidly in a short period of time and then crashing down to give up most of the earlier gain. Even if many stocks within the sector crash to lose most of a recent gain, the cumulative effect of all stocks in the sector going through this process at slightly different times will be a generally bullish sector.
Therefore, when good individual stock picks cannot be found, or when individual stock behavior is treacherous, it makes sense to invest in indices or sector ETFs. Savvy traders have learned the importance of tracking and ranking a wide range of ETFs on a daily basis. Because? Even when individual stocks may maintain their trends, it’s helpful to know where the pockets of strength are in the market. When stocks cannot maintain their trends, the scanning process reveals alternatives to individual stocks. How do you know when to use ETFs instead of individual stocks? The problem depends on whether the new market trend has enough internal momentum to support individual stock trends long enough to make them profitable. If you buy several stocks a little above price where there is significant support and the setup suggests the stock wants to go higher, but in each case the stock sells off enough that you lose all or most of the gain, then it’s probably too early to invest in individual stocks.
For example, an easy way to monitor the development of a new uptrend in the market is to look at the Dow 50-day moving average. If the 50-day moving average is rising and the closing price is above the 50-day average, the Index can be considered to be in an uptrend. The angle of rise of this moving average together with its consistency can tell you about the strength of the new trend. In a strongly rising market, the index will stay above the moving average, sometimes rising well above it and other times drifting or falling until it meets the average again. When it hits the average, it should bounce back on fresh momentum higher. If the 50-day moving average is rising strongly, then a good entry time is usually when the stock first starts to rise after finding the average. Experienced traders consider this to be a relatively low risk entry point. Because? It is considered low risk because the support offered by a strong 50-day moving average is nearby and because the stop loss can be placed near your buy price (just below the 50-day moving average). The index would have to sink through the support offered by the average to trigger its stop loss. Such penetration would indicate that something is wrong and that the position is one that you do not want to hold. To invest in the Dow, a person could buy shares of DIA, an ETF that invests in the 30 stocks that make up the Dow.
Now expand the concept. When the market is falling, you might consider investing in the Rydex Ursa no-load fund (Ursa is a “negative S&P500 fund” that goes up when the S&P500 goes down). Then, when the market rises, you can buy DIA (the Dow Jones) or SPY (the S&P500) stocks until the individual stocks meet your “buy” requirements or until they start to trend that don’t break immediately. Either method of using a cash balance should yield better returns than a money market fund. There are a variety of ETFs that can be used when individual stocks are still too volatile, even though the market or certain sectors of the market are trending higher. If you are a utility investor, you could use a utility SPDR based on S&P Utilities (symbol = XLU) just as you would use SPY for a multi-sector account. When the 50-day average (or other indicators you monitor) convince you that the market is in decline that may persist for a while, you might invest in the Ursa fund or an ETF that rises when the market falls. You could short the Dow with DOG, short the NASDAQ with PSQ, short the S&P500 with SH, short the S&P Midcap 400 with MYY, and so on. There are also ultra ETFs that look for daily investment results that double the results of a target index. For example, Ultra QQQ ProShares looks for daily investment results, before fees and expenses, that are twice (200%) the daily return of the NASDAQ-100.
The point and purpose here is not to turn individual stock investors into ETF investors. It is to offer suggestions for investing in a rising market even when timely individual stocks cannot be found, or for profit in a declining market when shorting individual stocks is too risky.
Copyright 2012, by Stock Disciplines, LLC. aka StockDisciplines.com