Nervous? Afraid to stay in but scared to get out? Join the club (and read my three strategies for coping)

11/20/2009 8:30 am EST


Jim Jubak

Founder and Editor,

Feeling twitchy?

Your portfolio is probably full of stocks trading at 52-week highs. And I’ll bet you’ve thought about selling.

And you would do that--except that the stock market keeps going up (well except for the last couple of days), cash pays close to nothing, and it’s hard to find a stock to buy that’s not already trading at its 52-week high.

I think you’ve got three choices at this point in this stock market.

  1. Sell despite the signs that this rally is likely to run into the first half of 2010. Your money will be safely in cash but you won’t make squat for six months.

  2. Hold if you’re fully invested and buy if you have some cash in the knowledge that you’re betting on market momentum and global cash flows to drive this market higher even in the absence of reliable forecasts for the economy and earnings in 2010. You’ll be hoping that you can somehow see the turn coming (or that there won’t be a turn) in time to beat the rest of the world’s investors out the door.

  3. Hold carefully and buy even more carefully when and only when you can find some fundamental facts that say the 52-week high isn’t a ceiling but a stopping off point on the way to a higher high.  After all Ford Motor (F) did climb to a new 52-week high at $8.98 a share from a 52-week low of just $1.01 a share. But the stock did trade above $14 in 2004. In that year the company made $1.59 in earnings per share. Wall Street estimates Ford will earn 43 cents a share in 2010. It’s clear that the stock will has upside from here if earnings come through.

I think there are problems with each of these three strategies. But I do think that if you take a dash of this and mix it with a pinch of that, you can come up with a strategy that limits risk and gives you decent upside exposure. Let me lay out that hybrid strategy for you and suggest a few stocks suited to playing mix and match.

First, build a cash management plan—and put it into effect.

There’s a huge difference between sitting out a nasty correction with all the money you had budgeted for college tuition, an annual tax payment, or the down payment on a house safely in cash and having to liquidate investments at fire sale prices and scrambling for cash. The last thing you want to do in a down turn is to take a big, temporary we hope, hit on your portfolio and then wind up losing a real estate deal or having to yank a kid out of college.

If you’re nervous about the next 6 to 12 months, cash out the money you anticipate you’ll need over that period at prices that are today 60% above where they were in March. If you have to keep $60,000 in cash so that you can sleep at night knowing that you’ve got your financial bases cover, then the loss of a potential gain on that money is, in my book, worth it. I’ve sold into this rally to sock away my kids’ tuition for 2010 and my 2010 tax payment. The cash is earning close to nothing, but the peace of mind, I’ve found, is considerable.

Second, momentum is real and it can be your friend if you let it.

Over and over during this rally I’ve heard from investors who have said, The stock market is ahead of the fundamentals of the economy or “This rally is built on nothing but the world’s central banks flooding the financial markets with liquidity.”

I totally agree. This is a liquidity driven rally. It is based on the huge influx of cash from government stimulus programs in countries such as the United States and China. The rally in commodities, commodity stocks, and emerging economy stock markets has been funded by money borrowed in what’s called the dollar carry trade. (In the carry trade big traders borrow U.S. dollars at very low U.S. interest rates and then use those dollars to buy assets promising higher returns such as commodities or Brazilian stocks. Eventually, of course, these dollar loans need to be repaid and these investments unwound.)

But that doesn’t mean that any dollar you make in this rally is worth any less than a dollar made on virtuous fundamentals. And the idea that somehow by participating in this rally investors are destroying the republic, motherhood, and the legacy of Warren Buffett and Ben Graham is, to my way of thinking, misguided. You take what the market gives you and if it’s a strong rally built on momentum you say Thank you.

And the momentum is, at the moment, very strong. It looks like stocks have just successfully tested their October lows and have moved above their October highs. Since I wrote  my post “You may not like the fundamentals but this rally is headed higher ( ) on November 16, the major indexes have moved to within striking distance of a 50% recovery of all the ground that they lost in the collapse from the October 2007 highs and then pulled back a tad. A move above what’s called a 50% retracement would signal technical analysts and momentum investors that this rally has further to run.

Technical analysis works because it summarizes in charts and numbers the psychology of large numbers of investors. There is still a huge amount of cash on the sidelines even after this rally. Much of that belongs to institutional investors who desperately don’t want to fall any further behind the performance of the market indexes. So they’ll put money into the rally because they feel they must. It’s that feeling that the technical indicators are capturing right now.

And what will these investors who feel they have to get invested buy?

They’ll buy the stocks—especially the big stocks—that have been going up. Hey, they don’t have time to wait for value stocks to show they’re value. They want performance now. Before the end of the year.

To take advantage of this momentum and this psychology, you too should buy the stocks that have been going up. Gold stocks such as Jubak’s Pick Goldcorp (GG) or Yamana Gold (AUY). Coal stocks such as Arch Coal (ACI). Technology stocks such as EMC (EMC) or Jubak’s Pick Corning (GLW). Mining stocks such as Vale (VALE) or (BHP Billiton, BHP).

The danger, especially if you aren’t an inveterate momentum investor, is that you’ll fall in love with these stocks and be unwilling to sell them in cold blood at the first sign that the technical indicators are turning down. If you buy on momentum, you have to sell on any turn in momentum. Otherwise you get killed. (Take it from someone who has died that death more than once.)

Fundamental investors who have temporarily decided to go with the momentum are particularly prone to the damage that comes from falling in love with what you own in a momentum market. They tend (I tend, to be honest) to justify holding onto a momentum buy even as the momentum fades because they believe in the company’s fundamental story. In a market trading on momentum, great fundamentals won’t save a stock when the momentum turns.

So how do you avoid this trap? One that’s especially dangerous after a 60% gain?

Try ETFs (Exchange Traded Funds). Sure, you may be susceptible to the lure of Deere’s (DE) fundamentals, but bury Deere inside the Market Vectors Agribusiness ETF (MOO) and the company is just one of a basket of stocks. It’s easier to be cold blooded.

This is one of the reasons that I own Market Vectors Brazil Small Cap ETF (BRF) in Jubak’s Picks rather than individual Brazilian stocks. At this stage in this momentum market it will be easier for me, given my bent as an investor, to sell the ETF than to sell Vale or Banco Itau (ITUB).

Third, the skeptics could be wrong and fundamentals could still count. In which case you should be now buying the great fundamental companies of 2010.

The argument that this is just a momentum rally based on massive flows of global liquidity is based on two things.

Huge observed flows of capital. I don’t think this is subjective or debatable. If you look at the money supply numbers for China, the size of the global stimulus packages, and the loose money policies of even the stodgy ol’ European Central Bank, there’s a tidal wave of liquidity driving markets higher.

A profound disbelief in an earnings recovery in 2010. This is subjective and debatable. We simply don’t have the data yet to tell us how strong individual global economies will be in 2010. And we don’t know how sustainable any economic recovery might be.

But we do know that the year to year comparisons in the March and June quarters of 2010 are going to be to some terrible quarters in 2009. In other words it won’t take much for earnings to look better on a year to year basis.

And we do know that some companies are coming out of this recession as lean, mean earnings machines.

Let’s take a Jubak’s Picks like Johnson Controls (JCI), for example.

Before this economic and financial crisis the goal of the auto interior business at Johnson Controls was global scale. The business unit could supply interiors for more than 30 million cars a year.

Which was great in the days when vehicles sales in the United States were running at 16 million units and in Europe at 21 million units.

But when global auto volumes crashed Johnson Controls lost money. Until the company took a scalpel to its cost structure. By the fourth quarter of the fiscal 2009 year that ended in September, the company had reduced costs until it can now break even when industry production in the United States is just 8.3 million vehicles a year and in Europe 14.3 million.

That means this business was actually profitable in all geographic regions in the fourth quarter of fiscal 2009—even as the global auto industry continued to struggle to emerge from its deep recession.

If the auto interior business was profitable when U.S. auto production volumes struggled to get back to 10 million units a year, think about the upside for this company with even a modest increase in production in the United States and Europe.

In the first two quarters of fiscal 2009, Johnson Controls lost $1.03 and 33 cents a share, respectively.

In the first two quarters of fiscal 2010, Wall Street expects Johnson Controls to swing to a modest profit of 27 cents and 25 cents a share on the way to a 583% increase in earnings for the entire fiscal year. Fiscal 2011 will bring another 38% increase in earnings. And those two years of amazing growth will take the company to earnings of just $2.06 a share in fiscal 2011.

I say just because in fiscal 2007, before the bottom fell out of the auto industry, the company made $2.13 a share. At its high in 2007 Johnson Controls traded at slightly less than $44 a share. The stock closed at $28.30 on November 17.

I’d say there’s some good gains based on fundamentals in this stock.

It’s not easy finding cost-cutting, fundamental growth stories like Johnson Controls. Deere, another member of Jubak’s Picks is one. So is Caterpillar (CAT) and the stock I’m going to add to Jubak’s Picks today Coach (COH).

These also have the advantage that they have pretty good momentum behind them.

I’ll have a complete write up of my buy on Coach posted later today.

Full disclosure: I own shares of Banco Itau, Corning, Deere, Johnson Controls, and Market Vectors Brazil Small Caps ETF in my personal portfolio.
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