Make the Market Work for You

 | Jan 31, 2013 | 2:30 PM EST
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A good friend of mine who trades the S&P 500 commented yesterday that if you had told him President Obama would win re-election handily and that the GOP would be forced to give in on both the fiscal cliff and the debt ceiling, he would have shorted the market to the maximum of his credit lines. The conventional wisdom was that all of those events would be horrible for the economy and the market would plunge. They all happened and bottoming at 1350 in November the stock market has shot right up to the 1500 area.

We are in one of these "all news is good news" markets. Amazon (AMZN) posted disappointing results according to the analysts, but the stock went higher. On Wednesday, the GDP report was the worst in some time. Had this happened in a different time period, we might have seen a stupendous selloff. But the market barely moved lower on the news.

Friends who track such things tell me that sentiment is mostly bullish and is at levels often associated with market tops. My technically oriented friends are tossing around terms such as "overbought" and "top of the bands." I think they mean the market is due for a pullback after a sharp increase. My options friends have put down their whiskey glasses long enough to warn of the consequences of very low volatility and growing complacency in options pricing. Macro types are telling me of global economic weakness, Arab nightmares and Chinese landings of various varieties that lead them to conclude we will see a selloff.

At times like these, I wish I stayed in school longer. The macro stuff makes almost no sense to me most of the time. When I look at most of these charts that folks like to show me, I feel like a little kid looking at clouds. I might see horsies and duckies, but I derive no information about what the market is or is not going to do. I understand the importance of high sentiment readings from a contrarian point of view, but I have seen sentiment stay too high or too low for extended periods of time over my career.

I get that the market has shot up very quickly in the aftermath of what many expected to be a politically driven crash that didn't happen. Although I do not watch the market trade tick-by-tick, I do generally make sure I know where my stocks are priced at any given time. I have seen to quick moves in Kelly Services (KELYA), Hess (HES), and the rocket-ship action on Bank of Ireland (IRE).

I am even aware that only 10% of the stocks in the S&P 500 are down for the year. I know that 60% of the index components went up more than 5% in the first month of trading and more than 20% are up double digits already this year. I am even smart enough to know that this type of action is kind of frothy and that those prices may need to rest for a bit. Yet I am not smart enough to know if these prices will move sideways for a bit, experience a correction or crash in spectacular fashion sometime soon.

When I get concerned about the markets and my technical and macro friends have me wanting to curl up under the table in body armor, I go through my portfolios stock by stock and ask two simple questions. First, is it still cheap? Bank of Ireland, for instance, may be up more than 30% all this year but there is no reason to rush to ring the register. The stock still trades at just 50% of tangible book value. If the stock is cheap, I keep it. If it has climbed up to a premium valuation, I sell it and add the proceeds to my cash balances.

Once we have determined which stocks are cheap and will be held for the long term (which is usually most of them), the second question is: "Is it safe?" Has something changed in the company's fundamentals that would lower its Z or F scores? Has business worsened to the point that the survival is an issue? If the answer is yes, I sell the stock and add the proceeds to cash.

The market is probably due for a pullback now. But being due doesn't mean it has to happen. By holding decent cash balances and selling stocks that are no longer safe can help give you additional firepower. Never chasing an up market can also help you from suffering in a decline. Approaching markets in this manner allows you to make the market work for you, and add to your portfolio in the inevitable pullbacks, corrections and crashes that will occur during your investing career.

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