Plan for the Impending Rally, Part 2

The market has given conflicting signals over the past several weeks. October 16th, the market logged a Follow-Through Day which often indicates a change in market trend. As IBD is fond of saying, “no market uptrend has ever started without a follow through day, but not every follow through day means a new bull market”. How should an investor reconcile what on the surface seems like contradictory advice? In part one of “Plan for the Impending Rally”, I said that investors need a system that at a minimum answers these four questions:

1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble

Before we go any further I just want to point out that during the week of October 22nd the market suffered two straight days of heavy volume losses coupled with a traumatic Friday start when the market opened with limit down curbs in place. The poor daily and weekly action negates the follow-through day mentioned above. Today, October 28th, the market logged yet another follow through day on decent volume and big price gains.

Now that the market direction may have changed, where do we go from here? The market is clearly whipsawing creating a dangerous environment. The media is filled with pundits calling this an opportunity of a life time and value investors have started to come into the market lead by Warren Buffet. Tread lightly.

As I mentioned in my prior posting, if you are a long term mutual fund investor with a 10+ year time frame keep putting money to work and double up if possible. In 20 years you will glad you did.

What should you do if you have a more speculative outlook? First review the four main points above and begin constructing an appropriate system so you can effectively invest in this challenging market environment which could last for years. There are literally thousand of stock market systems out there but keep in mind you must find one that matches your market outlook and personal psychology. Be realistic and know that it will take several years to master a given system so in the meantime how should you operate in today’s’ market?

Here is a game plan to consider. The plan allows you to spot a potential market turning point, identify new leadership, pick strong stocks and effectively manage your money.

1. Look for the market to log follow through day. This indicates a potential change in market direction and could potentially signal the long anticipated bottom. This event occurred today.
2. Now that the market has followed through, look for stocks making new highs while preferably breaking out of new bases. Ideally you would find several stocks form the same industry group moving in tandem to new highs. This is an excellent way to confirm market sector leadership.
3. The bear market has damaged just about every stock, so even though a follow through occurred not many stocks may fit the parameters mentioned above. You must exercise patience and resist the urge to jump in because you will miss big gains. We are in a nasty correction and you must exercise skepticism above all else and make the market prove itself before you risk your hard earned money.
4. Once you have found a stock that meets your selection criteria, make a small initial purchase as close to the proper buy point as possible. The initial purchase should be only a very small amount of your total portfolio. My last initial buy used only 2.5% of my total portfolio, but I risked even less. More on that below.
5. Put a stop in place when you make you initial buy. I normally put my stop loss at 5% below my first purchase price but you could go as far as a 10% stop. My experience is that once a stock begins to show a loss it will eventually hit my stop so I try to get out as cheaply as possible.
6. Stops limit what you actually risk in the market. For instance if you purchase $5,000 worth of stock with a 5% stop you aren’t wagering that total amount but just $250 which on a $100,000 portfolio equals just .025%. Think about this the next time you see the whole market swoon 10%.
7. If the initial buy shows a profit, add more as the stock gains 2-2.5% from your last purchase price. Make three buys of even amounts and be sure you do not buy any further than 5% past a proper buy point.
8. If your stock increases enough to make three buys make sure you have stop in place to protect that whole position. Again I prefer a 5% stop for a complete position.
9. If the first position is a winner look for a second stock to buy. The market has shown strength so now repeat steps 4-7 but it is safe to increase the amount of capital that you use from 2.5 of your total portfolio to 4% when making the next purchase. Don’t forget the stop!
10. If your first position is stopped out take it as a danger signal. The market is not working for you. Consider sitting on the sidelines but if you are compelled to make another stock purchase repeat steps 4-7 but this time only use 1.5% of your portfolio take make that first buy and don’t forget the stop!
11. If you buy three stocks and you stop out on all three take three weeks off before making any more buys. Use the time to evaluate the overall market condition because three strikes is the market’s way of telling you something is wrong. This is by far that hardest thing that I have to force myself to do because I have a psychological weakness that I believe the market will increase. I have put this rule in place to protect me from myself.

In closing the market has followed through indicating a potential change of trend. Use a sound set of trading principals like the ones outlined above of search for one that fits your own personal style. Above all, exercise caution and use stops to protect yourself in a dangerous market.