4 Ways to Win in a Wild Market

07/31/2012 9:30 am EST

Focus: STRATEGIES

Jim Jubak

Founder and Editor, JubakPicks.com

Investors trying to cope with stocks' recent volatility are simply creating more ups and downs, so this trend will be with us for a while. Here's how to profit from it, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

And market volatility begat more market volatility.

That's not a quotation from some obscure piece of Scripture, but a description of how market volatility, over a long enough period, changes investor behavior to guarantee more volatility.

And if that's so, investors need to adapt their strategies and be prepared to handle the wild ups and downs. Call today's column my attempt at "Winning Strategies for the New Volatility."

How Wild Is It?
Think back to August of last year. From August 10 to August 15, the S&P 500 climbed 7.4%. And then from August 15 to August 19, the index gave almost all of that back, falling 7.1%. And then from August 19 to August 30, the index climbed 7.9%.

Be honest. Doesn't that history figure into your thinking about the rally/bounce/whatever that started on Thursday, July 26, and took the index up 3.6% in two days? Aren't you thinking about those 7% moves in four or five days in August 2011 and measuring the distance to the door (especially if you remember the bigger moves in 2011, such as the 16.3% tumble from July 6 to August 10)?

Doesn't that history make you think about sitting out the summer and coming back in October (especially since the S&P 500 gained 22.1% from October. 3 to October 26)?

And honestly now, don't you think about the fact that despite all this volatility, the stock market, as measured by the S&P 500 index close, was on Friday almost exactly (1,385.97) where it was on April 28 (1,360.48)?

Doesn't that make you want to do more trading, or sell winners sooner so you can buy them back cheaper in a week or month, or play momentum and forget all about fundamentals and long-term value? Doesn't it make you want to do something to take advantage of the volatility or to avoid getting hurt by it?

Of course it does. And it should. But recognize at the same time that those responses to volatility guarantee that the volatility will continue, and probably even increase. And recognize that it's not just the behavior and strategies of individual investors that feed the market's volatility. Institutional investors are reacting to the market's volatility with moves that increase that volatility.

For the five market days ended July 24, investors pulled $11.5 billion out of US equity funds, as they watched the Dow Jones Industrial Average fall by triple digits on three consecutive days. That's the biggest outflow in two years, according to cash-flow data from Lipper (which, by the way, reports based on market weeks ending on Tuesdays).

Much of that outflow came through exchange traded funds that track the S&P 500 and that are a favorite way for institutional investors to react to market volatility.

I wouldn't be at all surprised to read that in the five market days that end on Tuesday, July 31, money sloshed back into US equity funds in reaction to the big bounce on Thursday and Friday of last week.

A Trader's Market
Is this any way to run a stock market? What happened to buying stocks based on the fundamentals of the underlying business? Or being willing to look past the events of a week to the month or even the quarter? Or about holding for longer terms?

I don't think the current market volatility has repealed the wisdom of those approaches to making money on stocks. But this market sure isn't going to pay you for following those approaches. At least not in the short run, and perhaps (I fear in my more pessimistic moments) not even in the midterm.

A good part of this increase in volatility comes from real, global macroeconomic trends: As the world copes with the uncertainties caused by huge government debt, rapidly aging populations, global cash imbalances, and a very painful slowdown in growth in the developed world, it's only to be expected that financial markets will show the strain. And increased volatility is a result of that strain.

Even if you don't buy that logic, and you believe these extreme short-term moves are irrational, they can still cost you real money. No matter what you check off as the cause of this volatility, I don't think simply pretending that it doesn't exist is a viable strategy.

So what do you do?

Fighting the Trend
I don't think there's any one perfect strategy for coping with this volatility. Volatility in the current market comes in a wide variety of time spans. And if as I think, this volatility will be with us for a while, investors should mix and match strategies for that variety of time spans.

Let me give you some suggestions organized by the time span of the volatility from short to long.

  • Swing trading. Very short—days or a week or two.

In the current market, I think it's very possible to come up with a short list of stocks with very clear trading patterns that have very clear relationships to the ebb and flow of macro fears and hopes.

For example, Spanish bank stocks such as Banco Santander (SAN) and Banco Bilbao Vizcaya Argentaria (BBVA) sink when the financial markets seem convinced that Spain is about to ask for a Greek-style bailout. They soar when the financial markets seem convinced that someone—the European Central Bank's Mario Draghi, most recently—is about to ride to the rescue.

Both extremes are, well, extreme, and the likelihood is that Spain will neither go the way of Greece—the country does have viable industries, and Spanish exports have climbed with a sinking euro—nor be saved overnight through some financing scheme that prevents years of pain.

When fear was in the saddle in May, I was able to buy the New York-traded ADRs of Banco Santander, to use a specific example from my Dividend Income portfolio, at $5.77 and $5.35. Then, when hope headed higher, I sold those lots at $5.97 and $6.35 in June.

And then, what do you know? Fear gained the upper hand in July. I was able to rebuy those lots at $5.19 and $4.90, then sell them again in the Draghi bounce at $5.83 and $5.93.

Other swing-trade candidates that I've used lately are tied to fears of a hard landing in China. When that fear rises, Chinese stocks in particular and emerging-market stocks in general fall. When hopes that China will stimulate its economy rise, so do these stocks.

Some stocks I've been using in these trades include Cemex (CX), Gerdau (GGB), and China Eastern Airlines (CEA).

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Caveats include watching transaction costs and time of execution, and keeping a constant watch for the breakdown of trading patterns. I've found that for the shortest of these overseas trades, American Depositary Receipts traded in the US work better than shares traded on their home markets.

I haven't used Gerdau in a swing trade lately, for example, because the Brazilian market has developed its own problems—related to the domestic economy in Brazil—that makes the trading range of Gerdau less reliable.

Dangers, besides getting it wrong, include losing out the gains of a stock that keeps on climbing after hitting what was once the top of its trading range. At the moment, Cemex looks like an example of that.

  • Sector trading. This strategy is for the medium term—a matter of a month or two, perhaps more.

Gold is a good example. With the euro falling and the US dollar rising, gold has been an unloved asset. Inflation didn't look like a danger with European economies dragging down the global economy and with the dollar rising, so the dollar-denominated value of gold fell.

The shares of gold miner Goldcorp (GG), a member of my Jubak's Picks portfolio, had rallied in the early part of the year—January through March—when investors believed that the loan facility that the European Central Bank had put together for European banks would make a lasting difference in the Eurozone debt crisis. But the shares, along with the shares of most gold miners and the price of gold itself, then fell and fell as investors came to believe that this lending facility was just another patch.

But recently, as the odds of more stimulus from the European Central Bank and another round of quantitative easing from the US Fed have increased, gold stocks and gold itself have rallied. Shares of Goldcorp have been one of the biggest winners in the Draghi bounce, rising almost 10% from the close on July 24 to the close on July 27.

Other commodity sectors—copper, for example—are worth considering as ways to take advantage of medium-term volatility. So, too, are the safest dividend-paying blue chips, which will turn into attractive safe havens the next time the market mood swings to fear.

For sector trading to work for you, you have to be willing to buy when these sectors are out of favor. You had to buy Goldcorp at $32 when everybody hated it in early July, and not now at $36.

Caveats include a need for patience, because sector trades take longer to turn around and can try your convictions. This is one reason that you should consider using dividend-paying stocks for your sector trades, such as Freeport McMoRan Copper & Gold (FCX) with its 3.7% dividend yield. (This stock is another member of my Jubak's Picks portfolio.)

Dangers include getting the sector trade wrong when fundamentals change —as happened to me with recently sold Jubak's Picks member Potash of Saskatchewan (POT) —or buying the wrong horse in the sector.

  • Seasonal trades. This strategy looks ahead six months or so.

Remember "buy in November and go away in May"? That has been a winning pattern back to the Depression, but the huge year-end rally that started in October and then petered out in April created a legion of new believers. (It didn't hurt that the rally of 2011 peaked at the end of April, of course.)

I think that a lot of investors have decided to sit out the summer in 2012, and are looking forward to a rally in the fall. (I know I'm not rushing to put the big cash position in Jubak's Picks to work during the summer months.)

Of course, rallies can fail to materialize even when everybody expects them. But they're just as likely to become self-fulfilling prophecies as everybody takes positions, driving up stock prices, in preparation for the expected move up.

This strategy right now would look to sit out a weak August and September and start buying depressed high-quality stocks in October. Some stocks to look at would include Coach (COH), Cummins (CMI) and Apple (AAPL), although the timing for Apple has more to do with the next iPhone than general seasonal factors.

Dangers include macroeconomic scares that could derail this seasonal pattern—the US fiscal cliff comes to mind.

  • Contrarian trades. This may not be the easiest time to be a long-term investor, but that doesn't mean you should give up on the strategy. In fact, the volatility in the current market will give investors with genuinely long time horizons—five years or more—a chance to buy cheap.

I can give you a list of places to look. I'd be looking at oil companies with big stakes in new frontier geologies of Southeast Asia, East Africa and the West African-South American belt such as BG Group (BRGYY), which trades in London as BG.LN, Pacific Rubiales (PEGFF), which trades in Toronto as PRE.CN, and New York-traded Talisman Energy (TLM).

Another choice is shares of cash-rich Japanese companies in the consumer sector, focusing on those with a big presence outside Japan. My favorite stock in that category is Seven & I (traded in Tokyo as 3382.JP), the owner of the global 7-Eleven convenience store brand. Japanese stocks are now trading at a near-20-year-low valuation.

Yes, I understand the worries about the Japanese economy, Japanese government debt, and Japanese demographics. But global Japanese consumer companies aren't doomed by those problems.

Caveats include a call for lots of patience while you wait. (Here again, dividends help: Seven & I pays 2.8%, for example.) Dangers include being so early that the eventual profit doesn't represent a very attractive annualized rate of return. I'd combat that problem by averaging in on the worst dips—such as now—and putting buying on hold during rallies.

So Which Way to Play?
This isn't an exhaustive list of either time frames or of the attractive opportunities within those time frames. Even so, it may strike you as exhausting. After all, it's hard enough to pursue one strategy successfully, let alone two or three.

But you don't need to have a position in each of these camps. Nor do you need to work equally hard at each strategy. Maybe one or two swing trades will do while you work on a "go away in May" strategy.
My point isn't that you have to do one or the other, or all, of these strategies. It's that you need to think about the possibility—the likelihood, to my way of thinking—that the current market volatility will be with us for a while and that we all need to figure out how to cope with it.

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, may or may not now own positions in any stock mentioned in this post. The fund owned shares of Apple, Banco Bilbao Vizcaya, Banco Santander, BG Group, Freeport McMoRan Copper & Gold, Gerdau, Goldcorp, Pacific Rubiales, Seven & I and Talisman Energy in March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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