Where's S&P 500 Support after Today's Big Drop? What should we do?

New Trading Range

Today, the stock market as represented by the Dow Jones Industrial Average dropped over 500 points for a loss of 4.41%. The S&P 500 dropped 59 points to 1192 for a 4.71% loss.

This drop was not unexpected. Around July of 2008, the S&P 500 hit a new low of 1200. Often, these lows are re-tested, and this is what we had today. We re-tested the lows and broke below previous support level.

We expect the S&P 500 to find a lower trading range.

Based on previous analysis, there's a good chance that the S&P 500 bottom could be between 1077, to 1172, a potential 10% drop from here.

Re-Evaluate Portfolio and Goals

So what should we do now? Over the long term, the stock market is the best place to be. However, this involves risk.

Have you looked at your goals and your portfolio and re-evaluated where you are? Do you need the money within the next five years? Do you have many decades to weather the storm? Do you have credit card debt? Do you have too much risk in your Discretionary Portfolio (as opposed to your retirement portfolio)?

Possible Ideas

So your main focus should be to re-evaluate your portfolio and your goals and your current financial situation. This should be the basis of many of your actions.

Depending on your high level game plan, here are a few tools:

1. Readjust allocation: Maybe you might want to have more cash or bonds, and less exposure to equity.
   
2. Stock or Sector Rotation: Maybe you might want to rotate away from sectors which are bad and rotate to the safer consumer staple names such as Procter and Gamble (PG).
   
3. More Diversification: Maybe you are too concentrated in your portfolio? Maybe you should readjust your portfolio to have better diversification.
   
4. Move towards ETFs, and Index Funds: Are you sure you can still keep up with your stock portfolio? Maybe you should consider just investing in broad based index funds, or ETFs. Or, you could do a combination of both for the Core and Explore method.
   

S&P 500 Trendline, Support and Resistance after Big Drop Today

The S&P 500 ($SPX) went down 38.82 points (-2.94%) to close at 1283.15.

Next support levels are the important 1270 and 1219 levels. (See the horizontal blue lines in chart above). The stock market could bounce on these support levels, or else these support levels could break and then we find new support levels and resistance levels.

Looking at the three year trend line (the blue diagonal trend line), we notice that that from 2005-2008, the blue diagonal trend line was support, establishing a trend. However, in 2008, we notice that the S&P 500 broke down below this trend line and remains below the trendline.

In chart analysis (also known as technical analysis), the usual rule is that support levels which have been breached now become resistance.

So now, the long three year trend line is the upper resistance of the S&P 500.

Let us first see how the S&P 500 behaves at the 1270 level, the first support level.

Today's Stock Chart

Overbought, Oversold, and Oscillators

Overbought and Oversold

Many pundits out there throw out the words overbought, and oversold when it comes to stocks or the major stock indices. Is there a way to keep track of overbought and oversold?

Oscillators

There are many technical indicators (special indicators by looking at the stock charts) to help determine oversold and overbought conditions. Oscillators are the most popular. At one point, a stock (or index) is overbought, and then at another point, it oscillates back to oversold.

S&P Oscillator

One popular Oscillator is the S&P (Standard and Poors) Oscillator, which is a proprietary Oscillator. In Jim Cramer's 'Real Money: Sane Investing in an Insane World', Jim Cramer mentions the proprietary S&P Oscillator as one way to spot a market bottom. He says that it costs around $1000 to subscribe.

On Jim Cramer's site TheStreet.com, Jim Cramer Says:

"When the oscillator is over five, people must sell, regardless of how great it looks," Cramer recommended. "There have been some [times] where the animal spirits of the market have been so great that it's gone to plus nine and 10, but the percentages on the upside are that there's going to be a selloff. It may not be major, but I do believe it will happen."

When it's over five, if he were fully invested, Cramer said he would cut to being 75% invested. At this time, short-term traders should maybe go 50% invested, and "if you're a guy who is able to short, maybe 25% short," he said. "That's how much I have faith in this indicator. I have faith in almost no indicators other than this one.

"Helene Meisler, [a contributor to RealMoney.com does] her own oscillator work," Cramer said. "She seems to agree with me on the site. When we both agree, we tend to have a pretty powerful correlation between right and wrong."

RSI Oscillator

For more inexpensive ways to determine oversold/overbought, one can use the RSI indicator. RSI stands for Relative Strength Index. When the RSI is over 70, the stock or index is overbought. When the RSI is under 30, the stock or index is oversold.

Of course, stocks or indices can remain oversold or overbought for long periods of times:



In the above example with Garmin (Chart of GRMN with RSI information here), we notice that when RSI is in overbought territory, GRMN is near its high, and when RSI is in oversold territory, GRMN is near its low.

Towards the middle of 2007, we do notice that GRMN remains in overbought territory, but GRMN makes very good gains during this time. This is an example of an overbought situation remaining overbought for long periods of time. The same can happen with oversold stocks or indices. Some technicians suggest to wait till the RSI goes down below 70 after remaining overbought, or wait for RSI to go up above 30 after remaining oversold.

Other Oscillators

There are many other oscillators as well such as using Bollinger Bands, or Stochastics. TradingDay has a good link to some of these oscillator methods.

Bottom Indicators

There are many other bottom indicators as well. Some oscillators above may be more suitable for traders and short term traders. But if one wants to find more long term investable bottoms, you can use some of these other methods:

1. S&P 500 Stocks Above the 50 and 200 Day Moving Average (Low value = Bottom)
   
2. S&P 500 High-Low Index (Low Value = Bottom)
   
3. 10 Day Moving Average of Put-Call Ratio (High value = bottom)
   
4. Ratio of Stocks Above 200 Day Moving Average to Stocks Above 50 Day Moving Average
   
5. Bull-Bear Ratio and Bullish Percentage
   
6. Index in Relation to 52 Week High and 52 Week Low
   

You would like to look at several of the different indicators and look at the support and resistance levels of a particular stock or index.

Strategic Portfolio Re-Allocation as Fed Cuts Rates (Aug. 21, 2007)

Fed expected to Cut

We've been experiencing a painful market correction centered around subprime problems, mortgages, and a US liquidity crunch. Because of all this, the Fed is now expected to cut the Fed's Funds Rate from 0.50% to 0.75% by First Quarter of 2008 from various sources.

Sector Rotation Model based on Fed Cutting Rates

When the Fed acts to raise or cut rates, we should act accordingly. These are important turning points. According to Standard and Poor's Sam Stovall's Sector Rotation Model, and Jim Cramer's Sector Rotation Model (Page 115 of his Jim Cramer's book: "Real Money: Sane Investing in an Insane World") as the Fed tightens or cuts rates, it is profitable to get out of certain sectors and into others.

In Jim Cramer's Sector Rotation Chart, we should be doing the following (Interpretation of the chart can differ depending on whether you look at GDP growth or look at the actions of the Fed):
1. Sell "smokestack" stocks such as Caterpillar (CAT), or 3M (MMM).
2. Sell metals and mineral stocks such as Alcoa (AA) or Newmont Mining (NEM)
3. Buy high multiple tech stocks such as Google (GOOG)
4. Buy Banks and Financials such as JP Morgan (JPM) or Wells Fargo (WFC)
5. Eventually, as the economy slows, buy Retailers.

However, there is another story that may conflict with the advice above: The Global Growth Story.

The Global Growth Story

Because emerging markets like China are growing fast, they need materials such as Copper, and industrial equipment like those made by Caterpillar (CAT). This goes against some of the advice based on the Sector Rotation model above.

I do believe the Global Growth Story is a multi-year/multi-decade long cycle.

Portfolio Strategic Repositioning

So what can we do to strategically position ourselves for the intermediate future?

I have several different portfolios with different styles (most are well diversified portfolios). However, in one of the portfolios, I apply a more concentrated method, and this is what I've been doing during the last month with this portfolio:

1. Sell Oil and Oil Services

Oil and Oil Services have not been doing well recently as crude prices have been going down and may settle in the $60 to $65 per barrel range. If we are to see an economic slowdown in the US, demand could weaken. Yes, over the long term, the global growth story needs oil. So while my concentrated portfolio has no oil, my long term diversified portfolios have sufficient exposure to this sector.

2. Sell Coal

Coal, as embodied by the stock Peabody Energy (BTU) has been going down. Peabody Energy reported reduced guidance because of delays in ramping production at recently acquired mines.

3. Sell Minerals

I took profits in Freeport McMoran (FCX) whose stock price had been dropping like a rock. Also, the Sector Rotation model above suggests that we do sell mineral stocks. However, I still believe in the Global Growth Story. I am looking for ways to get back into Freeport McMoran (FCX), a Gold and Copper company.

4. Sell Selected Financial Companies

Goldman Sachs (GS) is a quality company, but it had been dropping hard, and during the time when it was uncertain that the Fed was going to do anything, I had to sell Goldman Sachs in order to stop the freefall and to raise cash to purchase other securities. Some of Goldman Sach's Hedge Funds suffered big losses.

5. Reduce Emerging Market Wireless Telecom (Overweight to Neutral)

I still believe in the strength of Emerging Market Wireless Telecom especially companies such as Mexico's America Movil (AMX). I had overweighted America Movil, but I reduced it to a neutral position so I can invest in other names.

6. Hold Computer and Video Gaming Company

I am continuing to hold Gamestop (GME), a retailer of computer and video game consoles, equipment and software. Gamestop has been doing well, and is part of the great Computer and Video Game Cycle. This cycle will remain strong, and Jim Cramer even mentions this very positively in a discussion with TheStreet.com's Michael Comeau.

7. Hold Infrastructure Company

Countries around the world needs infrastructure as they grow, and I continue to hold ABB Limited (ABB), a Swiss Infrastructure company providing power and automation technologies to utility and industry customers worldwide. Infrastructure is still needed around the world.

8. Overweight High Growth Tech:

Currently continuing to hold Google (GOOG), Apple (AAPL), and added Garmin (GRMN) and all have been doing well recently. These are the key high tech growth stories that can be owned for many years. They are the leaders, and innovators, and their forward PE ratio are all under 30 for their great growth. The sector rotation model also suggests this, and these stocks have held up well during the downturn and will do very well in the future.

9. Add Selected Financials with No Subprime Risk

After discovering that a financial company, Hudson City Bank (HCBK) had been holding up well during the most recent market correction where financial companies stock prices were being punished, I decided to look deeper. James Altucher, of TheStreet.com pointed out a link to the Bergen Reporter. The article, written by Dunstan Prial, says that "Officials at Hudson City Savings Bank, Columbia Bank and Valley National Bank said fallout from the subprime mortgage crisis that has roiled markets in recent weeks has so far been minimal. The primary reason, said Hudson City Chief Executive Officer Ron Hermance, is smaller regional banks tend to hold on to the mortgages they generate instead of reselling them into so-called secondary markets, where they are resold as investment products." CNN even reports that Hudson City Bancorp is the Anti-Countrywide. Jim Cramer also is bullish on regional banks in this part of the cycle.

Hudson City Bank is also a fast growing bank with conservative lending practices. In a falling rate environment with many financials suffering from a liquidity crunch and subprime problems, Hudson City Bank (HCBK) stands to benefit.

10. Hold and Add to Cash Rich Companies with Great Investors

Leucadia (LUK) is a cash rich company run by two Guru investors, Ian Cumming and Joseph Steinberg. American Real Estate Partners (ACP) is a very cash rich Real Estate company that recently includes veteran activist investor Carl Icahn. In a cash strapped environment, whoever has cash holds a very valuable commodity. And if the allocator of Capital is a talented investor such as Ian Cumming, Joseph Steinberg, and Carl Icahn, who like to buy undervalued and distressed securities, then the return on investment is even better.

I continue to accumulate Leucadia (LUK) and have added a position in ACP (American Real Estate Partners). Both have held up very well during the market downturn and both will do well in this environment.

11. Hold Aerospace Company

The Aerospace Cycle is still strong. Boeing (BA) would be an obvious play, but I continue to hold Transdigm Group (TDG). Transdigm Group is a $1.8 Billion company, with a forward PE of 15.55, a five year estimated growth rate of 28.5% for a very low Price Earnings to Growth (PEG) ratio of 0.55, very cheap! (less than 1 is very cheap).

12. Hold Defense Play

The defense bull market is still there, and is levered more to government spending than consumer spending. Obvious names include Raytheon (RTN) or Lockheed Martin (LMT), but I prefer investing in Harris (HRS).

Harris (HRS) is a $7.7 Billion company that provides special equipment to the government and the military. They operate four segments, Government Communications Systems, RF Communications, Microwave Communications and Broadcast Communications. It has a forward PE of 15.11 and a five year estimated growth rate of 27% for a very low PEG of 0.56.

13. Hold Emerging Market Beverage Play

I continue to hold Wimm Bill Dann (WBD), a high growth diary and juice producer in Russia. This play should not have a large correlation with the US Financial situation and is more levered to the local Russian economy. TheStreet.com Ratings often lists Wimm Bill Dann as one of its five top growing stocks.

Is the Correction Over? Possible Bull and Bear Scenario on S&P 500 (August 17, 2007)

What a week we've had! The stock market goes up and down many percent each day. On Thursday, August 16, 2007, the S&P 500 Index ($SPX) opened down near the expected intermediate bottom area of 1365 ($SPX bottomed at 1370). There was panic in the market. But towards the end of the day, the market had a massive rally to finish almost even.

Thursday appeared to be a capitulation ("I surrender!") bottom and the nice recovery helped solidify that. Friday continued the Fibonacci bounce to the 1440 (38.2%) to 1463 (50%) levels.

Fibonacci Theory says that the 38.2%, 50%, and 61.8% numbers occur all throughout nature, and also in stock charts. You can place a Fibonacci Grid (the five blue horizontal lines in the chart above) with all those numbers from a high to a low or from a low to high. Resistance and Support levels often occur at these levels. If other support and resistance levels, such as the moving average or horizontal or trend line resistance occurs at those areas, then the Fibonacci lines are valid.

During a market drop, after the market hits some sort of bottom, the market often bounces to one of the fibonacci levels. It should bounce to at least the 38.2% level (1441) which was already passed on Friday, August 17. If the bounce is strong, the stock or index could bounce to the 50% level (1463) or even 61.8% level (1485). Then, the stock or index would reverse after that retracement.

In the $SPX chart, there is also congestion around the 1463 level.

So from today onwards, I expect a bounce to reach somewhere around the 1463 level. Then, I expect $SPX to reverse.

V shaped market bottoms are not very stable. What often happens is that sometime later (possible a week or so after the first bottom is made), the stock or index would re-test the lows. In the chart above, I expect $SPX to re-test near the previous lows of 1370. But the $SPX could go down to 1365 or so and then recover, and still be a successful re-test.

Now at this point, there is no edge in determining whether the $SPX will break down and start a new lower trading range, or it will bounce off the previous lows and form some sort of a Bullish double bottom.

If it breaks below the previous lows on good volume, we could see a new lower trader range, the bearish case.

However, if the $SPX bounces off the previous lows, this is bullish. We tested the previous lows twice and succeeded, forming a bullish double bottom.

At this point, we don't necessarily go straight up. The $SPX will mostly take time to consolidate, and eventually settle around 1441 to 1485 trading range. This would be consistent with the congestion that occured earlier at those levels.

After sufficient time, (maybe in the November/December timeframe), the $SPX would break out from this trading range and start challenging the previous all-time highs as part of the seasonal 4th quarter rally.


Today's Chart

Stocks Above 50 Day Moving Average after Drop Today (August 15, 2007)

The Stock market has been experiencing a correction, and the S&P 500 Index ($SPX) only has 7.6% of its stocks above the 50 day moving average. This is very low!

What are these stocks holding up?

I used Yahoo Finance and selected the larger capitalization stocks above the 50 day moving average and above a $4 Billion market capitalization:

1. Procter and Gamble (PG)
   
2. Cisco (CSCO)
   
3. Pepsi (PEP)
   
4. Ebay (EBAY)
   
5. Alcan (AL)
   
6. Las Vegas Sands (LVS)
   
7. Kimberly Clark (KMB)
   
8. Southern Co (SO)
   
9. FPL Group (FPL)
   
10. Celgene (CELG)
    
11. Kellogg (K)
    
12. Garmin (GRMN)
    
13. Broadcom (BRCM)
    
14. Macronix Intl (MXIC)
    
15. Hilton Hotels (HLT)
    
16. LG Philips (LPL)
    
17. Biogen Idec (BIIB)
    
18. Paychex (PAYX)
    
19. Wrigley (WWY)
    
20. Juniper Networks (JNPR)
    
21. Wynn Resorts (WYNN)
    
22. Lyondell Chemical (LYO)
    
23. Nidec (NJ)
    
24. Leucadia (LUK)
    
25. Intuitive Surgical (ISRG)
    
26. Intercontinental Hotel (IHG)
    
27. Hudson City Bancorp (HCBK)
    
28. American Real Estate (ACP)
    
29. Amylin Pharma (AMLN)
    
30. Waters Corp (WAT)
    
31. Tim Hortons (THI)
    
32. Dade Behring (DADE)
    
33. Whole Foods Market (WFMI)
    
34. Barr Pharma (BRL)
    
35. Iron Mountain (IRM)
    
36. Navteq (NVT)
    
37. Dow Jones (DJ)
    
38. Vertex Pharma (VRTX)
    
39. Covance (CVD)
    
40. Trimble Navigation (TRMB)
    
41. Intersil Corp (ISIL)
    
42. LDK Solar (LDK)
    
43. Weight Watchers (WTW)
    
44. Stericycle (SRCL)
    
45. Hansen Natural (HANS)
    
46. China South Air (ZNH)
    
47. Checkfree Corp (CKFR)
    
48. Chaparral Steel (CHAP)
    

I'm not surprised seeing consumer staples companies such as Procter and Gamble (PG) and Kellogg (K). I'm not surprised seeing healthcare stocks such as Celgene (CELG).

As many commentators have pointed out, technology can be good. Ebay (EBAY) is on the list, and Location Based Service stocks such as Garmin (GRMN), Navteq (NVT), and Trimble (TRMB) are good. I'm surprised that Broadcom (BRCM) is on the list.

I also noticed several resorts such as WYNN and Las Vegas Sands (LVS), most likely because of Macau presence and eased Macau rules, and that even in slowdowns, people can still gamble.

Hotels such as Hilton Hotels (HLT) and Intercontinental Hotel (IHG) are also on the list.

I'm surprised by Hudson City Bancorp (HCBK), a Financial. How is this surviving?

I'm also surprised by American Real Estate (ACP). How is this surviving in this market?

Lower Trading Range on S&P 500 after Today's Drop (August 15, 2007)

Today, Wednesday August 15, 2007, the S&P 500 ($SPX) dropped 1.39% to 1406.70. The $SPX dropped below previous good support of 1427, and that level is now resistance.

Where are the next more significant support levels on the $SPX?

In order to determine this, we have to take a 2 year view of the $SPX.

I put a Raff Regression Channel (orange uptrending three line channel) which shows the trend channel, and also the support and resistance levels. 1400 is a support level. The middle line also nicely marks resistance on the early August bounce.

I also put a Fibonacci Grid (five blue horizontal parallel lines) from the Late 2005 lows to the July 2007 highs. Fibonacci theory says that the numbers 38.2%, 50% and 61.8% show up in nature and in charts over and over again. If these lines coincide with other resistance levels (such as moving averages or horizontal resistance), the support levels and resistance levels defined by these lines are more valid.

In this case, $SPX has already gone below the 38.2% retracement (1410), and the next target zone is the 50% retracement of 1364. This 50% retracement level also coincides with horizontal resistance (previous low occurred around 1364 around March 2007), so we can have more confidence with this support level.

RSI, the Relative Strength Index, is still at 33 and has not gone down below 30. So we aren't extremely oversold according to that metric, though the Stocks under 200 Day Moving Average Metric ($SPXA50R), is a very low 34.20%. Numbers under 45% are usually signs that the end bottom could be near.

However, this is a fearful market, and I expect a new trading range between 1364 and 1427 on the $SPX.

Long Term Investor Suggestions

Over a very long time, stocks have outperformed bonds and inflation according to Professor Jeremy Siegel, author of Stocks for the Long Run. So it would be okay to be mostly invested in your discretionary portfolio.

However, rotate out of stocks that are not working, and rotate into stocks that are doing well and holding up well throughout this correction.

For those who want to Hedge without Put Options or Traders

If you want to hedge the portfolio without using Options, you can use Proshares ETFs. Proshares offers double short ETFs such as SDS. SDS is the Double Short S&P 500 ETF. If the S&P goes down 1x, SDS goes UP 2x. So as the market goes down, you profit using SDS. However, if the market goes up, you lose money with SDS.

In general, you would not want to hold SDS for a very long time. You can sell the SDS after it hits a target area, such as 1380 or 1365 on the $SPX.

For traders, once we get an idea where the intermediate bottom is, we can determine how to play a bounce. But we don't know exactly where the intermediate bottom is. Maybe 1365-1380 on the $SPX?

On TheStreet.com, Roger Nusbaum writes about Hedging a Portfolio with Double Short ETFs.

Today's Chart with many of the the indicators above

Lessons Learned from the Last Bear Market

The Great Bubble ended in 2000, and the Great Bear Market of 2000 to 2002 ensued, and brutalized stocks and portfolios. The Dow Jones Industrial Average dropped 38% from January 14, 2000 (11723) to October 9, 2002 (7286.27). The Nasdaq dropped even further, falling 78% from March 10, 2000 (5048.62) to October 9, 2002 (1114.11).

Investors and traders lost fortunes during this very difficult time.

Can anything be learned from this traumatic event? What lessons can we learn?

1. Valuation does matter.

During the Bubble which preceded the Great Bear Market, the valuations of large capitalization stocks especially tech stocks and tech stocks on the Nasdaq rose to unprecedented and astronomical levels.

Jeremy Siegel, in an article in the Wall Street Journal in March 2000 titled "Big-Cap Stocks are a Suckers Bet", says that of the 33 largest firms based on market capitalization (those with values greater than $85 billion), 18 of those were technology stocks, and their market weighted PE equaled 125.9. Mr. Siegel also notes that half of the large cap technology stocks had P/Es over 100.

Even if we look at the trailing PE of the more conservative of S&P 500 during the Bubble, we notice that the PE ratio went up to 35, when historical trailing PE is 14.1 and the trailing PE of the S&P 500 is 17.1 as of May 2007.

In addition, during this time, many people thought this was a different era, and that new methods were needed to justify the extreme valuations of tech stocks.

In 1999, Louis Corrigan writes about Michael Mauboussin in 1999, the head of value based research at C.S. First Boston. In this article, Louis Corrigan explains Mr. Mauboussin's position:

1. "We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."
   




2. "Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture."
   



3. In Louis Corrigan's introduction to Mr. Mauboussin's work, Mr. Corrigan says:
   

   "Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups."
   

Even Fed Chairman Alan Greenspan repeatedly warned people of "irrational exuberance".

With unsupportable valuations, it was only a matter of time before the market corrected itself to more reasonable levels. Valuations, apparently, does (eventually) matter.

2. Buy and Homework not Buy and Hold

People at the time, had often learned to "Buy and Hold" but people misunderstood this and applied this to Dot-Com stocks and high flying tech stocks.

Professor Jeremy Siegel, economist and author of "Stocks For the Long Run"(1st edition published 1994), proclaimed that over the long term, stocks have nearly always outperformed bonds and inflation. And that even if you bought some of the most expensive stocks at the worst possible time (such as the "Nifty Fifty" growth stocks of the 1970s), you could still make money as long as you just hung on.

Of course, people who followed this strategy without regard to price suffered during the Great Bubble and Bear Market.

In an interview with Money Magazine in 2004, Jeremy Siegel responds to a few questions regarding this:

Q. In the 1990s a lot of people used your finding that stocks nearly always make money in the long run to justify some pretty aggressive investing. Did you feel like Dr. Frankenstein -- you know, like, "I've created a monster"?

A. [Laughs.] Somewhat. I worried that people would interpret my message as "Just buy stocks without any attention to price."

Now I wish that in the second edition of "Stocks for the Long Run" I would have warned much more loudly -- but at that point it wasn't as out of hand as it got. And I was speaking out in 1999 and 2000 against what was going on with Internet and technology stocks.

Still, if you ride the bubble up and down, you do darn well indexing the stock market in the long run -- about 7 percent annualized, after inflation. I never told people that there wouldn't be a bubble or a bear market. I just said that indexing has done well over time.

Q. Would you modify the message now?

A. I now think that you could do better. After what I saw in 2000, I concluded that by applying some common sense and reducing your exposure to the hottest sectors and stocks, you could pick up about half a percentage point more return, on average, each year. If you just stay away from these manias, you've got an edge.

At the top of the bubble, I moved away from tech stocks. I repositioned my-self. I still held money in an S&P 500 index fund, so I didn't entirely sidestep it, but I moved a lot into value. And boy did that help me on the downside.

Then I said, if I did that and it helped so much, let me explore whether staying away from wildly priced growth stocks is something that works over much longer periods of time.

[...]

Q. You observed in "Stocks for the Long Run" that investors could make money even if they bought the high-flying stocks of the 1970s at their peak. Now you're saying that investors shouldn't buy expensive stocks. A contradiction?

A. I'll tell you why it's not contradictory. Among the fast-growing stocks dubbed the Nifty Fifty, those in the cheapest 25 did much better than the more expensive half. I mention that in the third edition of "Stocks for the Long Run."

When people are paying 100 times earnings for big companies, you better watch out.

But right now growth stocks look cheap to me. You shouldn't be afraid to pay for growth. The average P/E ratio of what I call the El Dorados -- the 20 top-performing companies since the inception of the S&P 500 -- was a few points above the market's average.

But none had a P/E over 27. [The S&P 500's average P/E today is 20.]

That links well with my findings on the Nifty Fifty. The most expensive ones -- the tech companies like Polaroid, Digital Equipment, Texas Instruments, IBM -- didn't do well at all.

Among the Nifty Fifty companies, only Johnson & Johnson, in retrospect, deserved a P/E over 50. The key, and it's a theme I talk about again and again, is not wildly overpaying. You almost never want to pay over 30 times earnings.

After this Bubble, I understand perfectly well why Jim Cramer preaches "Buy and Homework" and not "Buy and Hold." Valuation does matter and holding absurdly overvalued stocks is not a good idea over the long term.

While some stocks recovered from the bubble, others, like some of the dotcom companies, are no longer in business, or their stock prices are more than 99% from their all-time highs.

One exception to "Buy and Hold" would be if an investor used very broadbased indexed funds or ETFs instead of individual stocks. More on this in the Diversified section below.

3. Markets can remain irrational for periods of time

Valuations of many tech and large cap companies were very expensive, and for a time, they became even more expensive. Markets can remain irrational for periods of time. And during this time, the largest gains in these stocks were made.

This is a very difficult time for all. Do you invest in a massively overvalued stock that keeps on going up? Or do you invest in value stocks and smaller capitalization stocks that were underperforming the market? During this period, those who were nimble enough to trade momentum, and get out at the top were rewarded, but many who learned "buy and hold" and applied it to overvalued tech stocks were badly burned.

Then there are those who avoided the whole bubble completely (and many were criticized for underperforming the "market" during that time) and invested in value oriented stocks and small and mid capitalization stocks and were greatly rewarded. The period from 2000-2007 favored small and mid cap stocks and value stocks.

4. Diversification is very important.

People learned that diversification is very important. If someone had ridden the dot-com companies from Bubble to Bear market, that person would have lost most of the value in their portfolio. If a person had diversified into small cap, mid cap and value stocks during this time, they would have lost less money and during the recovery, these stocks outperformed the Nasdaq and the S&P 500.

From March 1, 2000 to July 30, 2007 (Adjusted for dividends):

1. Nasdaq: -46% (4784.08 to 2583.28)
   
2. S&P 500: +6.87% (1379.19 to 1473.91)
   
3. S&P Midcap 400: +92.37% (468.71 to 866.31)
   
4. S&P SmallCap 600: +96.67% (219.57 to 413.86)
   

If an investor had an indexed portfolio of ETFs representing the S&P 500, the Midcap 400 and the Smallcap 600 and invested near the Bear Market Peak on March 2000, and held to July 2007, that person would have had a decent return because of the large gains in the Midcap and Smallcap Indices.

5. Diversify from your own company stock

People also learned that they needed to diversify away from their own companies stock. People were very bullish on their own stock. But when the Great Bear Market showed itself, many of those people were laid off at the same time their company stock started plunging. This was a bad combination. People need to diversify away from their own company stock!

6. Many people survived the Great Bear Market of 2000-2002

While many people suffered and lost their jobs during this painful time, many people have recovered from such a brutal Bear market. We are still here and we are the survivors.

What's a correction after you've experienced a very deep and painful Bear Market?

How I'm Staying Calm during this Wild and Volatile Market Correction (Aug. 9, 2007)

I've seen investors go from euphoria as the the Dow passes 14,000 to panic and fear as the Dow has many down 300 days, and later get more excited as we have new rallies. As the market continues its correction (or bear market?), people are experiencing all sorts of emotions including fear. Even Jim Cramer on a "Stop Trading!" segment on CNBC shows his passion during a rant about the Fed.

Yet despite all this and the fact that I've lost some money recently, I've managed to keep my emotions in check. How am I doing this?

1. I believe in the long term power of stocks and the global growth story.

Over a long time period, investing in the stock market is a very good way to grow your money. Over the long term, stocks have returned around 10% per year. According to Schwab Center Research with data from Ibbotson Associates, the longer you hold stocks, the less chance you have of experiencing a negative return.

The table below represents the range of S&P 500 returns from 1926 to 2005. Total returns includes reinvestment of dividends. If you held the S&P 500 index for three years, your annualized return would range between 31.2% gain to a 27% loss. If you held the S&P 500 index for a period of 20 years, your annual return would range from a gain of 3.1% to a gain of 17.9%.

Chart Provided by Charles Schwab.


Stocks, over the long term, will do fine!

James Altucher writes about seven reasons to be bullish in this article, though some people would question if all those points remain true with the recent US credit crunch.

2. I've experienced many corrections before.

Having seen corrections before, I know that this too, will pass. If you look at charts from a longer time period, you'll notice that these corrections are just blips in a stock market whose very long term uptrend is up.

I've also incorrectly sold many of my stocks in my brokerage account during a market correction, only to see the market bounce back again and I had to repurchase a large portion of my portfolio. If I believe in the long term growth of the stock market, and the economy is not heading towards a recession or depression, why sell during a market correction?

3. I've experienced a Bear Market Before

I've experienced a Great Bubble and the Bear Market that followed it, and today's situation doesn't look like it at all. I remember the stock prices of many companies with NO EARNINGS went to the roof. I remember the PE ratios of companies like Yahoo (YHOO) go to astronomical heights during the Bubble.

Jeremy Siegel, in an article in the Wall Street Journal in March 2000 titled "Big-Cap Stocks are a Suckers Bet", says that of the 33 largest firms based on market capitalization (those with values greater than $85 billion), 18 of those were technology stocks, and their market weighted PE equaled 125.9. Mr. Siegel also notes that half of the large cap technology stocks had P/Es over 100.

Even if we look at the trailing PE of the more conservative of S&P 500 during the Bubble, we notice that the PE ratio went up to 35, when historical trailing PE is 14.1 and the trailing PE of the S&P 500 is 17.1 as of May 2007.

I also recently re-read an article about Michael Mauboussin in 1999, the head of value based research as C.S. First Boston. In this article, Louis Corrigan explains Mr. Mauboussin's position:

a. "We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."

b. "Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture."

c. In Louis Corrigan's introduction to Mr. Mauboussin's work, Mr. Corrigan says:
"Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups."


Does today's situation look anywhere close to the last Great Bubble and Bear Market?


4. I learned technical analysis.

If I didn't know technical analysis, I would be dependent on emotions and I would just go for an emotional rollercoaster.

Once I learned technical analysis, I'm able to take emotion out of the equation. I learned about trend lines, support levels, resistance levels, Fibonacci retracement, re-testing lows, and many other technical analysis concepts. Rather than just blindly follow the market and let my emotions contol me, I could analyze the chart and estimate how far a market could bounce and where potential bottoms may occur. When the market gaps down near a resistance area and then stages a late day massive rally, I know what that may mean.

With technical analysis, I could objectively look at the situation and not be a slave to my emotions.

5. I am hedging my portfolio using double short ETFs.

Recent innovations include Exchange Traded Funds (ETFs) that short or double short different market indices. Proshares offers ETFs that short or double short the market. For example, if you buy the ETF SDS, and if the S&P 500 goes down 5%, then SDS will gain 10%.

With this new hedging tool, and with my knowledge of techical analysis, I could implement a hedging strategy without having to use Put Options. This hedging strategy is also good because it prevents me from having to get whipsawed as I try to sell my stocks during wild and volatile corrections, only to have to rebuy my much of my portfolio as the market goes up again.

(Link to article by Roger Nusbaum on TheStreet.com regarding hedging using double short ETFs.)

As an example, in June 2007, the S&P 500 ($SPX) had fallen hard three straight days. There was a possibility that the $SPX could fall even further below the 50 day moving average. So as a hedge, I automatically set an order that if the $SPX goes a certain percentage below the support level (in this case, the 50 day moving average), I would automatically buy SDS.

As it turns out, the $SPX bounced from this level and rallied for almost two months. Then, in late July 2007, the market started to correct. But since my automatic order to buy SDS (remember, this is a double short S&P 500, meaning I profit twice when the S&P 500 index goes down once) was still active, I ended up with a profit.

Near this point, I started seeing the $SPX was getting very oversold. It was time to sell my SDS for a profit.

I then formulated a possible scenario of a bottom, and I expected a Fibonacci retracement bounce ranging from 38.2% to 50% to 61.8%.

Based on the expected Fibonacci retracement oversold rally bounce and expected re-test of lows, I decided to automatically buy SDS if the $SPX reaches 1500 which was triggered at the end of August 8. On August 9, 2007, the $SPX dropped big all the way to 1453. Again, I have SDS for a profit.

That's where we are now. I could sell SDS for a profit, and then, set an automatic buy if the $SPX goes a percentage below the previous low of 1427.


Because of all the factors above, I'm keeping my emotions in check, and looking at the market more objectively despite the wild and volatile nature of this market.

Stocks Holding Up Despite a Big Down Dow 387 Day (Aug. 9, 2007)

The Dow Jones went down 387 points today, for a loss of 2.83% to end at 13270.68. But despite this big drop, there are stocks which went up today.

Here are a few of those stocks on my screen that went up despite a big drop in the market.

1. Leucadia (LUK): (Up 6% today)

Leucadia (LUK) is a company that many call a mini Berkshire Hathaway (BRK.B), Warren Buffet's Company. Management is excellent, led by Guru Investor Ian Cumming and Joseph Steinberg. In 1978, Cumming and Steinberg banded together to take control of the company for $100,000 of their own money and $1.2 million from others to grow it to a $10 Billion company today. Both are still active in the company and as of 2007, Mr. Cumming is 65 and Mr. Steinberg is 63 years old.

Leucadia is a holding company that uses a deep value investing approach, buying distressed companies at discount prices, and sell them for profits.

In a shareholder letter, Mr. Cumming and Mr. Steinberg say:

"We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values which we believe there are. From time to time, we sell parts of these operations when prices in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long term record…. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated. To mutilate a hackneyed phrase, we are old dogs and we can't learn new tricks-we believe the ones we learned over the last 30 years continue to work just fine."

The company's stock has gone up recently on good volume and is now very near its all time high. In March 2007, they announced a stock buy-back program.

2. Hansen Natural (HANS): (Up 1.43% today)

Hansen Natural is a $4.3 Billion Drink Company that specializes in the specialty Energy Drink Business. They have a forward PE of 23.44, a 5 year estimated growth rate of 28.59%, for a good PEG of 0.81 (less than 1 is good).

Hansen Natural (HANS) recently announced very good results, and JP Morgan analyst Dara Mohsenian said that catalysts include "improved distribution, contributions from the new Java Monster coffee drink, market share gains, entry into the on-premise market and international growth." Mohsenian also says that strong earnings growth "puts Hansen in a solid position to implement 16-ounce price increases if it chooses, which could be a very significant earnings per share driver" in an Associated Press article.


3. Central European Distribution Corporation (CEDC): (Up 2.51% today)

CEDC is a Polish Vodka producer and importer of other alcoholic and non-alcoholic beverages. The company is a $1.77 Billion company, with a Forward PE of 20.94, a five year estimated growth rate of 17.5% for a reasonable PEG of 1.19.

4. Middleby (MIDD): (Up 5.34% today)

Middleby is a $1.2 Billion company that designs, manufactures and sells cooking equipment and related products. The company has a forward PE of 21.06, a five year estimated growth rate of 18.5%, for a reasonable PEG of 1.13. It recently announced record earnings.

5. Allscripts Healthcare Solutions (MDRX): (Up 4% today)

Allscripts is a $1.44 Billion company that provides clinical software and connectivity and information systems for physicians. It has a forward PE of 32.07, a five year estimated growth rate of 30.44 for a reasonable PEG of 1.05. The company recently announced earnings.

6. Peabody Energy (BTU): (Up 3.17% today)

Peabody Energy is a $12.25 Billion US based Coal Company with a forward PE of 15.06, a five year estimated growth rate of 16.6% for a PEG of 0.91. The Coal sector has been beaten up recently, but a recent US Department of Energy report suggesting coal demand should increase this year is helping stocks in this sector.

7. Sirf Technologies (SIRF): (Up 4.28% today)

Sirf Technologies makes chips for the global positioning market. This $1 Billion company has a forward PE of 15, a five year estimated growth rate of 26.86% for a good PEG of 0.55 (less than 1 is cheap). The company has missed its quarter recently, and the stock is near its 52 week lows.

8. Stanley (SXE): (Up 2.61% today)

Stanley is a $500 Million company that makes information technology systems for the US defense and federal civilian government agencies. Forward PE is 19.11, five year estimated growth of 21.57%, for a good PEG of 0.89. On July 18, 2007, Navy announces a $23.1 Million Deal, where Stanley is one of the four military contractors which won the award.

9. Level 3 Communications (LVLT): (Up 4.87% today)

Level 3 is an $8.23 Billion company that is in the communications business in North America and in Europe. Among many telecom services, Level 3 also is in the fiber optic networking area.


Companies which show strength during big down days are companies you should watch out as they may lead the way when the market does come back.

(Do beware of short squeeze rallies though.)