Trade in Groups

Do you feel like this is the kind of market you’re trading in? Join the club…

Throughout most of 2007, the stock market displayed a great deal of serial correlation, where the leading stocks continued to outperform, and the lagging stocks fell even further. It threw value investors in particular for a loop, but helped momentum traders show great returns. And while the stock price action didn’t always make sense, the underlying reason for the narrowing of leadership seems due to the now-recognized shaky state of the economy.

As financials and consumer discretionary were falling, commodities and high-growth tech were rising to epic tops, as were a few other select institutional favorites. One by one, these stocks – Apple (AAPL), Research in Motion (RIMM), Freeport McMoRan (FCX), Potash (POT), Visa (V) – and others have seen their share prices destroyed in waves of high-volume selling. Very little has been “working” for short-term, long-focused traders. For example, there were 5 stocks that made 52-week highs today on the Nasdaq and NYSE; there were 778 that made new 52-week lows. The measures are equally skewed in terms of extreme overbought/oversold indicators, which is further evidence that buying dips is not the strategy to have because stocks have continually gotten cheaper.

From analyzing the Sector SPDR ETFs, the only sector which is not down more than 15% is Consumer Staples, which is down a mere 2% thanks to a strong performance from Wal-Mart (WMT), up 33%. Even traditional safe havens like Health Care and Utilities are down 15% and 20%, respectively. Is there a safe place to tread in this market on the long side?

The obvious area to look at first is the large cap consumer staples that have shown the ability  to hold up. Procter & Gamble (PG), for instance, is trading on the low end of its historical cash flow and earnings multiples. The same is true for Coca-Cola (KO) and Johnson & Johnson (JNJ). These might not be the most exciting stocks in the world, but in an environment where capital preservation is placed ahead of capital appreciation, long holdings like these can help you sleep easy at night. Is it a coincidence that on Monday’s 778-point Dow sell-off, the only stock in the S&P 500 that traded higher was Campbell’s Soup (CPB)? I think large institutional investors are telegraphing their extreme risk aversion right now, and are placing their bets accordingly.

I have a contact whom I regard as very market-savvy, and he suggested that until all leadership is gone and the markets have picked through and discarded every industry, we won’t be able to find a true long-term bottom. That’s extreme, but correct on an intuitive level, because it will mark the point of maximum pessimism.

The most important thing right now is to know thy positions – do a thorough tire-kicking of each, with special attention to outside-the-box risk assessment. Buy cash rich companies with solid business models, preferably where a large stock buyback authorization already exists. Consider selling covered calls on stocks if the upfront income justifies surrendering upside at a time like this; volatility is very high and thus options prices are rich. But most importantly, try to remove yourself to a higher plane than the day-to-day marks on your positions. I had a position that was up over 25% today, only to end flat – that’s the kind of market we’re in; accept it rather than fighting it.

Volatility can be stressful, so best wishes for a quiet weekend.