by James B. Stewart
The correction that made such a brief appearance two weeks ago has returned, this time apparently to stay. For me and anyone following the Common Sense system, that means opportunity.
Last week, the Nasdaq dropped convincingly below the Common Sense buying threshold, which is a 10% decline from the most recent high reached on April 23. The S&P 500 also dropped more than 10% from its peak, putting both major averages into an official correction, the first since the bull market began its rise on March 10, 2009. The Dow Jones Industrial Average dropped below the 10% correction threshold Thursday, returned above the line Friday and fell back below it again Monday. The Common Sense approach calls for buying on corrections of 10%, and selling after rallies of 25%.
Just two weeks ago I fretted that a buying opportunity had come and gone so fast I was unable to take advantage of it. The $1 trillion rescue plan unveiled by the European Union and the International Monetary Fund had triggered a huge rally, and it looked like the bull market was back. I needn't have worried. European sovereign worries have returned with a vengeance. Not only did the market's plunge renew a buying opportunity, but indexes fell so rapidly last week that the Nasdaq Composite was well below the 10% threshold on Thursday, when I made some purchases.
This is yet another reminder to remain focused on the long term and not get caught up in the minute-by-minute or even daily gyrations of the stock market. I've said for months that eventually there would be a correction, and not just one lasting a few minutes.
Having gone through three successive selling opportunities during the past year, I had ample cash at my disposal. (I generally sell roughly 10% of my portfolio at each selling opportunity and spend about 20% of my cash at each buying window.) In deciding what to buy, I simply followed the advice I've offered in recent columns. One strategy was to add exposure to commercial real estate, a sector I'd shunned as overvalued but recently concluded showed promise. I'll give a more detailed report on my real estate strategy in a future column, but one component was simply to buy a diversified exchange-traded fund, the Vanguard REIT Index Fund (NYSEArca: VNQ - News).
For stocks, I focused on some of my own recent recommendations in the technology sector. Despite generally solid earnings, the tech sector has corrected more severely than the broad market. I bought long-term Apple (NYSE: AAPL - News) calls at only a modest premium to the current price (I already have a position in Apple shares), as well as the PowerShares QQQ (NasdaqGM: QQQQ - News) exchange-traded fund, which approximates the performance of the Nasdaq. I've been impressed recently with strong earnings from big technology concerns like Intel (NasdaqGS: INTC - News), Cisco Systems (NasdaqGS: CSCO - News), and Oracle (NasdaqGS: ORCL - News), which account for three of the fund's top 10 holdings. (Apple is its largest position.)
I also raised cash by selling some Google (NasdaqGS: GOOG - News) puts. This is the first time I've sold puts in over a year. (Selling puts means you agree to buy shares at the strike price if they're trading below that price when they expire.) It's a strategy I recommend when option prices are high (such as when the VIX has jumped, as it did last week) and when I expect shares to rally. If you really hope to own the shares, I find you're better off buying them outright or buying calls. I wouldn't mind owning Google at the strike price, but since I already have a substantial position, I'm also happy to simply keep the cash should the puts expire above the strike price.
I did all these transactions last Thursday afternoon, as the Dow Jones Industrial Average was heading toward a 376-point one-day loss. With the previous brief correction fresh in my mind, I moved quickly in case the window proved fleeting. I needn't have; stocks were still in correction territory this week.
My reaction illustrates the persistence of psychological factors, even after years of investing. Why was I so concerned this correction would be brief? After waiting more than a year for a buying opportunity, the rising market has conditioned me to expect more of the same: a brief correction followed by the return of the bull. I was eager to put money to work and get it out of low-yielding money-market funds. And yet I realized my eagerness should have been tempered by the likelihood that this may not be the last correction. If history is any guide, the fact that there hasn't been a correction for so long increases the chances that there will be another 10% decline.
So I still have cash in reserve. As usual, I'm making no short-term predictions about the direction of the market. My goal is simply to be prepared when opportunities present themselves, as they did last week.
Copyrighted, SmartMoney.com. All Rights Reserved.