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Editor's note: The following is a recap of a "Mad Money" episode that originally aired Dec. 27, 2007.
In an inevitable market downturn, it's crucial that investors keep their heads and follow a specific playbook, Jim Cramer told viewers of his "Mad Money" TV show.
"I don't want you to panic," Cramer said. "I don't want you to run around anymore like a chicken with its head cut off. ... I want you to sit back and take a deep breath, calm down and do the right thing."
Investors can't keep calm without a playbook, Cramer stressed. Declines are inevitable, and too many regular people approach them like they're the end of the world. Cramer said pundits fail to acknowledge that the market has naturally occurring down days.
The key to a playbook for down days is that you should never let turbulence in the market scare you out of keeping your eye on the prize, Cramer said. "There are opportunities in every market. ... When stocks come down, they get cheaper."
On a down day, it's important to be able to tell the difference between real opportunities and fake ones. Cramer said that he made the most money on down days "because I got in at the right price range."
When there's a huge selloff, investors shouldn't kick themselves, but should maximize the opportunities a correction affords. Cramer actually hoped for corrections during his final years as a hedge fund manager. "Stocks that go lower that you like you can buy more of at lower prices," he said.
Investors often make the mistake of burying their heads in the sand, avoiding the news because it's just too painful. Cramer believes this is a wrong approach: "You know when you want to pay the most attention to stocks? When they're going lower."
Have Cash Available
To take advantage on down days, investors are going to need cash. "Most homegamers are fully invested all the time, meaning their portfolio is 100% stock and zero cash. ... My rule is to never have less than 5% cash," Cramer said.
Because corrections are inevitable, it's important to have cash available to buy stocks when they get cheaper.
"A selloff is only as good or bad as you make it," Cramer said. "If you own nothing and you're trying to build up your portfolio, a selloff is a gift."
Circle the Wagons
Cramer suggested that investors make a list of stock they own and every stock they're considering. Stocks can be divided into four categories.
"Rank them every Friday," Cramer said. "Wait until you have a free moment to catch your breath." It doesn't pay to try to rank stocks in the heat of the trading day.
The first stocks are "ones you're trying to back the truck up on. These are the stocks you plan on buying, period. They're your serious conviction names." Second are the ones that are buys, but only if they come lower. Third are stocks "you own and would sell, but only if they rally 5 to 7 percent." The fourth set of stocks is made up of "stocks you own and want to sell right now," Cramer said.
A smart investor will examine this list with total honesty, Cramer said. "When you get hit with a big selloff, that's going to change ratings." During that time, it's important that investors re-evaluate their positions.
"In a selloff, you don't want to sell nothing and buy more of everything. That's reckless," Cramer said. It's not panicking to sell members of the third and fourth groups, and if investors sell them at the beginning of a decline, they'll be a lot better off. It's important not to try to tough out a bad day with the least appealing stocks in a portfolio.
During a bad day, investors should shift their capital to stocks on the first and second lists. The money to buy those stocks will come from selling the stocks on the third and fourth lists, Cramer said. When the market gets hit hard, investors should throw out their worst stocks and "circle the wagons" to buy the best stocks.
Buy Broken Stocks, Not Broken Companies
A selloff is full of "opportunities to buy good companies whose stocks have become bad," Cramer said. "In a really serious correction, almost everything will go down." That's when investors should look to be getting into attractive stocks.
"Certainly, a lot of stocks that don't deserve to go down will decline alongside those that do deserve to go down," Cramer said. It's important to be able to "discern between a broken company and a broken stock."
Cramer pointed to the selloffs of 2007 as an example. During the collapse of companies that issued mortgages, particularly those that had bonds, a credit crisis emerged, and along with that came selloffs. This hurt the financials and the homebuilders.
, for example, fell 47% in 2007.)
During a selloff, Cramer stressed, "look at the companies that caused it. They're probably broken. ... If you're looking at a company that's part of the reason for a correction, you're in the wrong place."
Cramer also mentioned that some companies that were not directly responsible for the market turmoil should also be avoided, if whatever caused the selloff should also cause a decline in those companies.
The retailers are an example of stocks that should have been avoided during the 2007 credit crunch. Because the liquidity crisis hurt the consumer, retailers' sales got hit, and the stocks declined. "A company becomes broken when the reason you had for liking it goes away," Cramer said.
On the other hand, in the 2007 selloff, there were many great infrastructure stocks that went down with the financials, homebuilders and retailers. Their businesses weren't broken, but their stocks came down, Cramer said. The companies behind these stocks didn't have much connection to the broader selloff, but their prices decreased. "You want to look for stocks in areas that are independent of what's ailing the market," Cramer said.
In a down market, it's tempting to shop for a bottom, trying to get stocks at their cheapest as they rebound, but Cramer said "that's rarely a safe bet."
Cramer said it's most important to "avoid broken companies at all cost."
A Mega Sale on Stocks
"A correction is, in the end, just a mega sale on stocks," Cramer said. When you go shopping at the store, you don't say you made a bad purchase because you got something cheap. He said it's important to take a similar attitude when approaching a market downturn.
The first place to look for opportunities, according to Cramer, is in stocks that have pulled back from their highs. Stocks that are hitting new highs tend to be more expensive, but when they get knocked off the new high list, they become more attractive.
Of course, some stocks coming off their highs will be going lower for good reasons, so it's important to choose wisely. "You'll have to use your discretion for each individual stock," Cramer said.
The rewards of picking correctly, though, are great, as stocks that are off their highs in a correction "recover hardest and fastest from the carnage unless again they are the reason for the carnage," Cramer said. Investors should have at least one stock that's off its high in their selloff playbook, so when the decline comes they can take advantage of it.
The second kind of stock to shop for during a correction is one with a dividend that becomes a whole lot more attractive as share price decreases, Cramer said. "A market correction will give you higher yields," he added.
"I know dividend investing isn't sexy," Cramer said, but "no one ever woke up unhappy" the morning after buying a stock that made them money. "You want stocks that are practically guaranteed to put money in your pocket."
Again, be careful, Cramer urged. A good rule of thumb is to look at a company's earnings. If the expected earnings are at least twice the size of the dividend, the stock is a safe bet.
Two Kinds of Selloffs
Cramer said that a selloff is "a real sustained period of negative action." A correction can be caused by by inflation or a recession, and the fear of either can spur a decline.
Cramer urged viewers: "When the market takes a 10% hit in under a month, don't get clever." No one can outsmart a down market. "Follow that darn herd," he said, at least for the duration of the negativity. "You're better off being attuned to the mood of the market than being right."
"When the Street thinks inflation is a problem, certain stocks go up. Most stocks go down. When the Street thinks recession is a problem, certain stocks go up. Most stocks go down," Cramer said. It doesn't matter whether the Street's view is correct. Investors shouldn't fight the sentiment.
During inflation-fueled selloffs, investors should buy gold or mineral stocks, which are anti-inflation plays. These stocks should preserve their value or go higher, Cramer said.
During slowdowns, "raid the supermarket aisles and the medicine chests." Soft goods and diagnostics are good bets for a recession, Cramer said.
"It's important that you not confuse these two things," Cramer emphasized. Buying the wrong stock during a selloff can be very painful.
Jim Cramer writes about all the stock trades in his charitable trust for TheStreet.com in Action Alerts Plus. Recent stocks he's traded in this account include Schering-Plough (SPG) - Get Simon Property Group, Inc. Report, Yamana Gold (AUY) - Get Yamana Gold Inc. Report and Abbott Laboratories (ABT) - Get Abbott Laboratories Report.
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