Go with the momentum? Or take profits? Here's my take on how to make that decision

10/28/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Should you go with the mo?

You know, momentum. The tendency of stocks that have been going up to keep going up (until they don’t, of course.) It’s a successful investment strategy built on the observation that stocks are the only thing that people want to buy more of as they get more expensive.

From the October 3 low through October 27, the Standard & Poor’s Stock Index was up almost 17%%. That’s enough to put thoughts of 2009 in anyone’s head. From the March low that year the S&P 500 rocketed ahead 13% in just about two weeks—and from there it had almost another 1,000 points to go before it topped out in April 28, 2011.

On the other hand, going with the Moe is one thing but nobody wants to be Curley or Shemp. The rally from the August 19 bottom to the August 30 high took the S&P 500 up 10%--but it wasn’t followed by another two years of roaring rally. Instead stocks reversed and by October 3 they had tumbled to a level below where they were on August 19. If you’d bought on August 30 after that 10% move upwards, you would have been left looking at a 9% loss by October 3.

So should you go with the mo? Should you hold positions that have rallied almost 17% or more in a little more than three weeks because momentum will take them higher? Should you buy in now if you’ve been sitting on the sidelines because you don’t want to miss out? Should you be taking profits and trimming positions to protect your gains from a potential downturn?

I’d love to be able to offer you some magic formula—“The inverse Mondavi function says this rally is going to 1364.3 on November 8—or astounding piece of fundamental wisdom—Comparing the multiples of the current market to all markets stretching back to 1843, shows that stocks will climb another 17%.

But I think the current market is best described as poised. The news flow can break either way, depending on what “solution” comes out of Europe in the next two weeks (when we have all the details we don’t have today.) Fundamentals can go either way with growth in Europe certain to slow but growth in the U.S. and Chinese economies set to come in either above or below the expectations built into stock prices right now. Technically, the charts show a market that may have broken through some tough ceiling levels where it’s still too soon to say if the trend will push through that resistance or falter and fall back from yesterday’s levels.

So what’s an investor to do?

My advice boils down to wait. For a little bit. Days not months. I know that you probably feel like you should be doing something right now. Either gobbling up momentum plays or selling everything in sight or, well, something. But sometimes waiting is your best investment choice. Right now I think this market is so poised between alternatives that the return on waiting is very high. A few days—maybe two weeks at the outside—should turn some of these points of indecision into actual trends that might run for a few weeks. Waiting may cost you a few of the bucks that you might have made if you guessed right on which way the market is about to break. But it will also save you the money you would have lost if you guessed wrong.

Most importantly, though, waiting a little bit will diminish the amount of guessing that you have to do at all.

Let me sketch in how I’m making sense of the market’s risk and rewards right now—and why I think waiting is a good investment. It will be up to you to figure out how my risk/reward calculus fits your own portfolio. But I’ll try to throw in specific suggestions for what you might buy or sell so that you can actually act on these calculations for your own portfolio.

Poised on news flow. News flow these days means the EuroZone. The more closely you’ve been following events, the more likely that your head is spinning. For example, on Wednesday October 26 at 1 p.m. I was reading an online headline “Impasse on Greek Debt Relief Threatens EU Crisis Summit Deal.” By 3 p.m. the headline was about rumors that China would invest in a European debt special investment vehicle. At 5 p.m. the headline was “U.S. Stocks Advance on EU Bank Agreement.” By 6:30 the headline was back to “Euro Weakens Against Dollar After Banks Say No EU Deal Yet on Debt Losses.” And by the morning the story was headlined “EU Sets 50% Greek Writedown, $1.4 trillion in Rescue Fund.”

Well, maybe. The deal, which is still evolving, is a bit light on details. Yes, the banks’ negotiators have agreed to a “voluntary” 50% write down but no one knows what will be offered to individual banks to get them to accept that deal. Yes, the leaders of the EuroZone have agreed to increase the firepower of the European Financial Stability Facility but the details of how that leverage will be created are still to come. It almost certainly involves some combination of some kind of insurance guarantee and a special purpose vehicle to entice investors from outside Europe, but in what combination is still being negotiated. And until we see the details no one can be quite certain how shaky this house of cards might be.

You may think you understand what this all means. I think I may understand what it all means. But I honestly know I could be totally wrong.

What I am sure of, however, is that the next few days will bring more details and some relative closure to these discussions—if not to the crisis itself. We will get, probably, a deeply flawed, frustratingly vague agreement—even if it includes more details than we have now--that will put off most of the tough decisions until later—again.

And, as important as having the agreement itself, we’ll know what the market reaction will be. That’s all worth waiting for.

How long to wait? With the meeting of the G20 leaders set to start on November 3, European leaders will have to flesh out their deal—as much as they can--by then.

What to do then? If we get a decent enough agreement to provoke a lasting (one day doesn’t count as lasting, mind you) positive stock market reaction, which is the most likely reaction, watch it drive up the price of European stocks and then use it to sell most European stocks. The European economy is going to slow in 2012 and you really don’t want to own most parts of it. The exceptions would be good but badly beaten up banks—Banco Bilbao Vizcaya (BBVA) and Banco Santander (STD) for example—but I don’t think you need to rush to buy them since we can expect another replay of the Greek crisis in December when Greece needs cash to avoid real default or later in 2012—and these banks will have to raise additional capital under the terms of the deal now being negotiated. After the next iteration of the crisis (or two) I’d also be looking to pick up shares in European companies that never sell off such as French luxury goods leader LVMH Moet Hennessy Louis Vuitton (LVMUY in New York or MC.FP in Paris.)

If the market reaction goes the other way on understandable disappointment or worry when everybody has seen all the details, still avoid Europe until these bargains materialize later in 2012.

The biggest winners from a successful—as judged by the stock market—resolution to the euro debt crisis—are likely to be emerging market stocks. If the market reacts positively (again for more than a day), consider Brazilian and Chinese stocks that have been killed in the crisis. In Brazil I’d look at steelmaker Gerdau (GGB) and Itau Unibanco (ITUB) on recent momentum. I’ve got a couple of China suggestions at the end of the next section on economic growth.

Poised on the global economy. This may take a bit longer since we really need a read not on the third quarter (which we got with numbers released on October 27 showing U.S. GDP growing at a 2.5% annual rate) but on the fourth quarter for the U.S. economy and on 2012 for China. Third quarter GDP growth for the U.S. came in surprisingly solid but now we need to know if that’s a fluke or not. For China, we need to know when the People’s Bank will start cutting interest rates.

How long to wait? For the U.S. fourth quarter the crucial week is likely to start on November 15 with retail sales, and then continue through the inflation numbers of November 16, and housing starts on November 17 and end with the due date of November 23 for the debt Super Committee. I think that will give us a clue on how weak the U.S. economy is for the end of the year—and with the Super Committee report on how weak it is likely to be in 2012. That week’s data is enough to give investors a sense of whether the market is going to get all-optimistic about growth or continue its August/September pessimism. We could know about the course of interest rates in China as soon as mid-November when we get another month of inflation data. If inflation continues to move down in this data, I’d be relatively confident of interest rate cuts in the first quarter of 2012.

What to do then? If U.S. growth is holding up, look for U.S. stocks to continue their rally into the end of the year. In that rally you would want to go with the mo—stocks that have moved up strongly are likely to continue to move up strongly as investors (particularly professional investors with end of the year reports to write) look to make up for a not terribly good year. Look to stocks that did well in the October rally—and that don't have complexities that might hold them back. Simple stories are good. Some examples are F5 Networks (FFIV) and Freeport McMoRan Copper and Gold (FCX), which should benefit from any positive news about growth in China and from the end of the strike in November at its big Grasberg mine in Indonesia. If growth is flagging, take profits and wait for the next opportunity.

Take a somewhat similar approach to China—but with the realization that since Shanghai and Hong Kong stocks have been so beaten up, the gains are likely to be more explosive on good news (and the track record for judging momentum is shorter.) Two stocks that have shows good momentum in the last week are insurer Ping An (PNGAY in New York and 2318.HK in Hong Kong) and Home Inns and Hotels Management (HMIN.)

Poised on the technical charts. The charts say that the Standard & Poor’s 500—which stood at 1242 at the October 26 close--is facing critical resistance at the June low of 1265 and the 200-day moving average at 1274. The S&P 500 closed well above those levels on October 27—that’s a very good sign. If the index can close above those levels for another day or so, I think it would be safe to say that stocks have broken resistance and are headed higher.

The close proximity of these two resistance levels makes this an even tougher and more important test. If the S&P 500 can clear this level, the next stop on the charts is near the July 7 close at 1353. Even if you don’t believe in technical analysis, lots of other investors do and a break above what the chart defines as resistance will give chart readers confidence that the market has another 100 points to run.

How long to wait? I suspect that this test will resolve itself one way of the other—with the news flow from Europe or with earnings or with U.S. economic numbers—within the next few days. A week at most.

What to do then? If the market fails this test, take profits. The pullback is likely to be of the dimensions of 10% or so. That’s a significant loss you’d like to avoid and if you have cash in hand, you can it to work at lower prices—if circumstances warrant. If the market passes the test, go with the mo using some of the stocks I’ve named above in the U.S., and China and other emerging markets.

Please remember I’m not trying to give you a long-term strategy here. My comments in this post are focused on investing for the next few months. Maybe less. Maybe much less.

The long-term question is whether or not we’re in a bear market punctuated by the occasional sharp rally. I have to admit that I’m pessimistic about that--certainly as far as the developed world is concerned. And I worry that if the U.S. economy slows too drastically even China isn’t a big enough engine to pull the global train all by itself.

But that’s a subject for December or January. Once the current poised market decides which way to break.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Bilbao Vizcaya, Banco Santander, Freeport McMoRan Copper and Gold, Gerdau, Home Inns and Hotels Management, Itau Unibanco, LVMH Moet Hennessy Louis Vuitton, and Ping An as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

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