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May 16, 2009

A Safe Bet in a Bear Market Rally

By Andrew Mickey, Q1 Publishing

Itís impossible to deny weíre in a bear market rally. The leading indices have climbed in spectacular fashion over the past few weeks. Theyíre up about 30% across the board.

Despite it all, there are still very few true believers in this rally. Now, after the first down week in months, it looks like the bears may be awakening from their hibernation.

Itís safe to say almost everyone wants to know whether the rally is truly done or whether this is a buying opportunity. As usual, a quick glance at a few headlines doesnít provide much help.

The San Francisco Chronicle is unusually direct in claiming, ďLosses signal stock market rally over.Ē

Editors at Forbes take a bleak outlook by saying, ďRally officially on hold after drop.Ē

A more subdued New York Times headline warns, ďWhatever you call it, this rally may not last.Ē

Frankly, itís nearly impossible to tell either way at this point. But that doesnít mean thereís no opportunity here. There is. And there is one simple strategy which will allow you take advantage of any upside safely and with limited risk. Let me explain.

History Tells a Different Story

There is a clear divide between the bulls and the bears right now. They both have a good case. On the bull side though, a lot of signs point to this rally having some life left in it.

First off, a lot of investors have been waiting for a dip like this. They missed out on the rally and theyíre itching to get back in. Most importantly, they have a lot of money to come in with. Earlier this week we looked at how thereís more than $5 trillion parked on the sidelines in money market funds. And Iím sure at least a part of that has been just waiting for a window of opportunity to move back in.

Thatís not all. History shows bear market rallies tend to last longer than eight weeks. For instance, the U.K.ís Telegraph says, ďThere have been nine bear rallies since 1970. The average length is four months.Ē So far, this rally has lasted just over two months.

The bear market rallies during the 89% decline from 1929 to 1932 are also good examples. During that time there were about four significant bear market rallies in the Dow. Those rallies peaked between two and five months after beginning. In each case the total rally lasted months beyond the peaks.

Basically, two months would be a very short bear market rally and itís too early to call this rally over yet.

Of course, there are still many potential speed bumps ahead. Rising unemployment, declining earnings, and an ongoing decline in real estate values are just a few.

Also, there have been no signs of a true bottom in stocks. There is still a lot of interest and hope out there. Also, market P/E ratios havenít fallen to lows of 5 or 6 and dividend yields havenít climbed very much and both of those happened in the past during true, long-term bottoms.

So Iím not about to go ďall inĒ yet, but Iím not going to let the rally completely pass me by. But thereís a way to do it, stay safe, and not take too much risk. To do that, Iíll be using one of the strategies which have done well every time I used it in the past decade. Iím not the first one to use it though.

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3 Out of 10 Ainít Bad

Bernard Baruch is one of the most successful speculators in history. He became a millionaire by the time he was 30 and went on to make an even greater fortune.

He got his start in the 1890ís which was the start of one of the most volatile periods in stock market history. By starting at that time, Baruch had to successfully navigate the Panics of 1896, 1901, and 1907.

How did he do it, you ask?

Well, he wasnít the greatest stock picker. He didnít manage to jump on a long bull market. He didnít have any significant edge against other speculators either. He actually attributes his success to something much different.

In the words of Baruch: ďIf a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.Ē

Itís the last part which really matters. Itís also where most investors make their biggest mistakes.

For most investors, they go in wanting to turn a quick buck. If a trade goes with them, they get out too early. If it goes against them, they become long-term investors.

In a bull market this leads to a string of 10% and 20% winners. There are ups and downs along the way, but the uptrend creates an ďitíll come backĒ mentality. In many case, it usually does come back.

When the market is not steadily rising (and covering up mistakes in the process), average investors inevitably get washed out. They turn the losers into long-term holds by refusing to take a loss.

This can destroy a portfolio and cause years of savings to disappear. Thatís why a lot of times, I recommend using trailing stops. Right now, with a very uncertain future ahead, is one of those times.

The Easy Way to Make a Tough Move

A trailing stop is similar to other buy and sells orders. The main difference is that itís automatic. It doesnít force you to make a conscious decision to sell a stock Ė a tough thing to do for a lot of investors. It takes all the emotion out of exiting a position.

For instance, letís say you bought shares of Kinross Gold (NYSE:KGC) at $16 per share this week. You go in thinking a gold mining stock should be a pretty safe bet here. Goldís been strong recently. And with all the freshly printed money floating around the world, inflation is inevitable.

Not bad rationale, but nothing is ever guaranteed. There are so many things which can go wrong. What if one of Kinrossís gold mines in Russia is suddenly nationalized? What if Kinross experiences a workerís strike at some of its mines? What ifÖwell, you get the picture. The stock price could fall.

Your rationale is good. Your timing is good. Everything looked good before buying in, but then something went wrong. Now, youíre down 20% and Kinross shares are falling three percent a day.

What do you do? Do you sell and take the loss? Do you take a stand against the market, buy more, and risk more losses?

Itís a tough decision to make. But if you use a trailing stop order, youíd be out at your predetermined price. If it drops below a predetermined point, the stock is automatically sold. Normally that point is set between 25% and 50% depending on volatility and how much youíre willing to risk.

A trailing stop order also allows you to participate in any run-up as well. A trailing stop ratchets up the exit point if the stock rises.

In the case of the theoretical Kinross example, look at what would happen if it goes up. Letís say Kinross shares double over the next year to $32. A 25% trailing stop will be moved up to $24. So if Kinross falls 25% from there, the shares will be automatically sold at $24 and you book an $8 per share profit. If they continue to climb, the exit point just moves up along with it and your minimum profit gets bigger and bigger.

Trailing stop orders, by moving up with a winner and stopping out a loser before it gets too bad, allows you to go along for the ride up and avoid a long and painful ride down.

Sticking to the Plan

In the end, I honestly donít know when or how this rally will end. With all that money on the sidelines, I believe this rally has a lot longer to run.

On top of that, there are still a lot of bets against the market out there. In other words, there are still big short positions out there. Itís tough to find shares to borrow in a lot of stocks and itís impossible in a few stocks to find shares to borrow.

The combination of both of those, new buying as well as short covering, could keep this market rally going for months longer than most anyone expects at this point.

Granted, the days of the consistent and sharp surges are probably past, but another 20% to 30% rise from here by the end of the year is definitely possible. I also expect a lot of weeks like the last one before itís over too.

But Iím not about to forget about the genuine risks out there which could easily stop the rally in its tracks.

As a result, Iím not about to take a big bet on the market at this point and donít want to miss out on continued gains as well. So I still recommend buying stocks which offer the best reward relative to the risks involved, but staying safe as well.

Trailing stop orders (offered by most discount and full service brokers) will be a part of that plan. Their unique features make them one of the safest bets in a bear market rally.

I doubt Baruch used trailing stops, but if the technology was available Iím sure he would. His success came from not being shy about cutting a loser. In the end, if this strategy worked during periods of extreme volatility, thereís no reason it shouldnít do well as we face a long period of volatility ahead.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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