Is it Time to Chase the Rally?

10/28/2011 8:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

You may be itching to get in, but tread carefully. Events over the next couple of weeks, including the apparent debt deal in Europe, will offer clues about the market’s direction.

Should you go with the mo’?

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

From the October 3 low through October 26, the S&P 500 was up 13%. 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 an additional 1,000 points to go before it topped out on April 28, 2011.

On the other hand, going with the mo’ is one thing, but nobody wants to be Curly 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 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 up, 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 13% 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? Should you be taking profits and trimming positions to protect your gains from a potential downturn?

Let’s try to figure all that out.

If Only We Knew
I’d love to be able to offer you some magic formula: “The inverse Mondavi function says this rally is going to 1,364.3 on November 8." Or an astounding piece of fundamental wisdom: “Comparing the multiples of the current market to all markets stretching back to 1843 shows that stocks will climb an additional 17%.”

But I think the current market is best described as poised. The news flow can break either way, depending on what debt-deal details come out of Europe in the next two weeks. Fundamentals can go either way, with growth in Europe certain to slow, but growth in the US 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 testing some tough ceiling levels, and it’s uncertain whether the trend will push through that resistance or fall back from those levels.

So what’s an investor to do? My advice boils down to wait.

I know 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 will diminish the amount of guessing that you have to do.

NEXT: Making Sense of the Mo’

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Making Sense of the Mo’
Let me sketch out for you how I’m making sense of the market’s risks 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 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:

  • On Wednesday at 1 p.m. I was reading an online headline that said “Impasse on Greek Debt Relief Threatens EU Crisis Summit Deal.”
  • By 3 p.m., the headlines were about rumors that China would invest in a European debt special investment vehicle.
  • At 5 p.m., the headline was “US 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 next 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 an 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 certain how shaky this house of cards might be.

You may think you understand what this all means. I think may I understand what it all means. But I also 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 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? The meeting of the G20 leaders set to start 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 positive stock market 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 banks—Banco Bilbao Vizcaya (BBVA) and Banco Santander (STD)—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 both have to raise additional capital under the terms of the deal now being negotiated.

After the next iteration (or two) of the crisis, 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 and MC.FP in Paris).

If the market reaction goes the other way on disappointment or worry after everybody has seen all the details, 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, consider Brazilian and Chinese stocks that have been killed in the crisis.

In Brazil, I’d look at steel-maker 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.

NEXT: Poised on the Global Economy

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Poised on the Global Economy
This may take a bit longer to figure out, because we really need a read not on the third quarter (which we got with US gross domestic product on October 27) but on the fourth quarter for the US economy and on 2012 for China.

Third-quarter GDP growth for the US came in surprisingly solid, but now we need to know whether that’s a fluke. For China, we need to know when the People’s Bank will start cutting interest rates.

How long to wait? For the US fourth quarter, the crucial week is likely to start on November 15 with retail sales, 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 supercommittee in Congress.

I think that will give us a clue on how weak the US economy is for the end of the year—and with the committee’s report, on how weak it is likely to be in 2012.

Meanwhile, the data are enough to give investors a sense of whether the market is going to become 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, I’d be relatively confident of interest-rate cuts in China in the first quarter of 2012.

What to do then? If US growth is holding up, look for US stocks to continue their rally into the end of the year. In that rally, you would want to go with the momentum.

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 & 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 because 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 shown good momentum in the past week are insurer Ping An (PNGAY in New York and 2318.HK in Hong Kong) and Home Inns & Hotels Management (HMIN).

Poised on the Technical Charts. The charts say that the S&P 500— which stood at 1,242 at the October 26 close—is facing critical resistance at the June low of 1,265 and the 200-day moving average of 1,274.

The close proximity of these two resistance levels makes this an even tougher and more important test. If the S&P 500 can clear these levels, the next stop on the charts is near the July 7 close at 1,353.

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 an additional 100 points to run.

How long to wait? I suspect that this test will resolve itself one way of the other—driven by the news flow from Europe or earnings or US economic numbers—within the next week to ten days.

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 put it to work at lower prices—if circumstances warrant.

If the market passes the test, go with the mo’ as described above in the US, China, and emerging markets.

Please remember, I’m not trying to give you a long-term strategy. My comments are focused on investing for the next few months.

The long-term question is whether or not we’re in a bear market punctuated by rallies. I have to admit that I’m pessimistic, certainly as far as the developed world is concerned. And I worry that if the US economy slows 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—after the current poised market decides which way to break.

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