Dear Member,

The biggest investment mistakes are often made during market corrections and bear markets. It is not uncommon for an investor to sell too late into the decline, locking in losses, and then wait for confirmation that rebound is underway, missing out on big gains. (Short-term reversals, like we had earlier this week, often magnify the mistakes by adding to the uncertainty of where stock prices are headed.)

Conventional wisdom suggests that investors turn off their televisions, avoid the financial news and take a deep breath. It’s good advice, but I think being proactive is an even better strategy. It is certainly better for those of you who feel the urge to do something. After all, ignoring the market’s gyrations is much like dieting: it is easier said than done.

Here are proactive steps you can start taking right now to help weather the market’s storm.

Create a shopping list. Market corrections, and particularly bear markets, put many stocks on sale. This makes periods of weakness a good time to look for industry leaders and stocks with good prospects. Write down the price you would buy at if the stock got cheap enough. Monitor the list regularly and if a stock comes close to your target, buy it.

An alternative suggested by Lauren Templeton, of Lauren Templeton Capital Management, is to place limit orders to buy stocks at significant discounts to their intrinsic value (based on discounted cash flow or valuation multiples). If the price falls to your target, the order is executed. As a safeguard, she advises looking for companies with no or low levels of debt. Lauren told me that her great uncle, Sir John Templeton, used this strategy throughout his career.

Sell existing holdings for better ones. One way to free up cash to purchase bargains is to sell stocks you currently own. The goal here is to exchange a current holding for a stock that has more upside potential but still provides diversification benefits. If you have a loss in a stock being sold from a taxable account, you get the added the tax bonus of locking in a capital loss. Just be sure the stock you are buying is truly a better pick.

Rebalance your portfolio. Rebalancing is the process of adjusting your portfolio allocations back to their target percentages. It forces you to buy low and sell high by moving money out of the best-performing asset class and into the worst-performing one. Over time, rebalancing will lower your portfolio’s volatility. Vanguard suggests rebalancing when allocations are more than 5% off target, and I think this is a good strategy.

Diversify your bond holdings. Yields on the 10-year Treasury are hovering just above 2%, but there higher yields elsewhere. High-quality corporate and municipal bonds can give you more income without significantly increasing risk. International bonds can also get you higher yields. High-yield bonds (aka junk bonds) do have a role, but only as a supplement to your bond holdings. If you will need the cash in the next couple of years, CDs or money market accounts are also options.

Spend more time researching investment ideas now. Throughout my career, I’ve seen investors make the mistake of not looking for investment candidates during market corrections and bear markets. This is the opposite of what they should have done. The best bargains are found during bear markets. Even if you don’t feel comfortable buying anything today or next week, you should start working on a list of what you would buy if the price was right. (See my first suggestion, “create a shopping list,” above.)

History has shown that there are rewards for those who are willing to be proactive when others are fearful. While there is never a free lunch on Wall Street, these strategies will lower your portfolio’s risk and increase the chance of profiting from the market’s eventual rebound.

Do you have a strategy for turbulent markets? If so, tell us on the AAII Discussion Boards.

How to Identify a Bargain

A stock is a bargain if it has strong fundamentals and is trading at a discount. This means you want companies that are adequately financed, have earnings growth and are trading at low valuations.

I pay particular attention to the price-to-book ratio. This compares a company’s market capitalization to the value of its net assets. As I explained in a July 2010 AAII Journal article, a well-managed company trading at or near book value is too cheaply valued, and is likely a bargain.

The Week Ahead

Four members of the S&P 500 are currently scheduled to report earnings next week. Joy Global (JOYG) and SAIC (SAI) will announce results on Wednesday; H&R Block (HRB) will announce results on Thursday; and Campbell Soup (CPB) will announce results on Friday.

The week’s first economic reports will be July personal income and spending and July pending home sales, both of which will be published on Monday. Tuesday will feature the Conference Board’s August consumer confidence survey, the June Case-Shiller home price index, and the minutes from the August Federal Open Market Committee meeting. The August ADP Employment Report, August Chicago PMI report, and July factory orders will be released on Wednesday. Thursday will feature the August ISM manufacturing survey, July construction spending, and the first revision to second-quarter productivity. August employment data, including the change in nonfarm payrolls and the unemployment rate, will be published on Friday.

Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak on Tuesday.

AAII Sentiment Survey

Bullish sentiment slightly improved in the latest AAII Sentiment Survey. The percentage of individual investors who expect stock prices to rise over the next six months edged up 0.9% to a four-week high of 36.4%. The historical average is 39%.

Neutral sentiment, expectations that stock prices will be essentially unchanged over the next six months, fell 2.0 percentage points to 22.6%. This is the sixth consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 1.1 percentage points to 41.0%. This is the 24th time in 27 weeks that pessimism has been above its historical average of 30%.

Bearish sentiment has been at or above 41% during three out of the last four weeks, equaling or exceeding one standard deviation above the average. This puts pessimism at high, but not excessive, levels. The numbers show continued uncertainty on the part of individual investors about where stock prices are headed. Market volatility, the slow pace of economic growth and sovereign debt concerns (both in the U.S. and in Europe) are all playing a role. The increase in bullish sentiment, however, shows that some individual investors believe that the selling pressure has made the prices of certain stocks attractive.

This week’s special question asked AAII members what, if anything, they have done in reaction to this month’s volatility. Answers varied, though the largest number of respondents said they bought stocks. The second-most-common response was that individual investors are looking for bargains among stocks. Making no changes came in third. A small number said they either sold stocks or were holding more cash (with proceeds coming from the selling of stocks, bonds, gold or short positions).

Here is a sampling of the responses:

• “Yes, I bought some stocks. I like things on sale!”
• “I’ve picked up a couple of bargains and am considering adding to my long-term holdings.”
• “I have taken advantage of the drop in prices to execute buys for stocks on my watch list. For many of these buys, the dividend yield is at 5%.”
• “Not much. I’ve looked for bargains and nibbled at one, but I am still waiting for better valuations to come.”
• “I have paid less attention to the markets and done nothing with my holdings. I am confident that stocks will rebound strongly later this year.”
• “I’ve gotten out of stocks and am battening down the hatchets.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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