Buy Into Bear Market Rallies

04/17/2008 12:00 am EST

Focus: MARKETS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Doug Fabian, editor of Successful Investing, suggests buying an ETF based on the Standard & Poor’s 500 to profit from bear market rallies.

During bear markets it’s not uncommon to see rallies lasting several weeks—or even several months. For example, from April 4, 2001 to May 21, 2001, the Standard & Poor’s 500 index surged 19%.  From September 21, 2001 to January 4, 2002, the S&P 500 surged 21.4%. 

These big rallies took place within the bear market of 2000-2002, and if history repeats itself in this bear market we could get some nice short-term upside despite the longer-term down trend in the overall market.

Now given what happened in the market [recently]—namely, a huge rally on Tuesday, April 1, followed by a stable and basically flat market in the succeeding three trading sessions—we could be ripe for another extended leg higher. (As of Wednesday, the S&P 500 is actually six points lower than it was on April 1st—Editor.)

To take advantage of what could be another sustained bear market rally, I am recommending you take the following action:  I want you to BUY the S&P Depository Receipts (Amex: SPY) with no more than 25% of your total portfolio.

This buy does, however, come with a few caveats.  First and foremost, I want you make this move ONLY if you consider yourself an aggressive investor; only you know how risk tolerant and/or risk averse you are. If you at all feel squeamish, then perhaps it would be better to stay 100% in cash.

If, however, you’ve been itching to put money into this market for the past three months but just didn’t know when to go for it, well, now is the time to pull the trigger.

The key to this strategy will be to have just enough portfolio exposure on the long side to take advantage of these bear market rallies, while at the same time not having too much exposure that could hurt us when the market declines.

If we get more upside here, then we will already have a 25% leg up on things by arriving at the party early.  If we are wrong about this buy, and if the market decides to take another big downturn, then we’ll remedy the situation via a tight stop loss on our SPY position.

We are placing a 5% trailing stop loss on SPY.  So, if SPY falls 5% below the highest closing price after our purchase, we will exit the position.  This 5% stop loss will keep us honest on the downside, and it will protect us against any real damage.

The great thing about this strategy of arriving early to the party is there’s a lot of upside to it, and only a small downside.

Finally, you have my permission to NOT take this buy if you don’t feel like deviating from our traditional domestic plan.  If you have any feelings of trepidation, honor those feelings and wait out this market in the safety of cash.

Of course, if you are feeling intrepid, then by all means—go for it!

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