Sneak Preview: Get the Right Rally Fit

A rising tide lifts some boats more than others, Cramer says in his new book.
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Editor's note: This is a special excerpt from Jim Cramer's book,

Jim Cramer's Mad Money: Watch TV, Get Rich

. To order your copy and read all the rules, click here.

9. When you're playing a big rally, make sure your stocks actually fit the bill.

Don't be bamboozled by a fuzzy belief that a stock may be levered to a particular sector: know precisely what you own and why you own it.

When you think you have a rally in a big-picture sector like health care or technology, you have to be very careful about what you buy. A sectorwide rally, unless it's part of a sector rotation caused by the business cycle, rarely ever happens. But you'll still hear a lot of talk about a "tech rally" or a "health-care rally" or even a "transports rally." When you know there's a rally, but it's being defined nebulously in terms of sectors rather than the industries that compose those sectors, you can't blindly buy anything that you think might fit the bill. You have to be careful and go over your stocks with a fine-tooth comb. What, precisely, is the rally in?

Figure out why there is a rally and which companies are actually driving it, then stick with those companies. Don't generalize out to the broader sector, because there probably isn't a broader rally. You have to know what you own and why you own it in the most concrete possible terms, especially when you've got a bullish situation on your hands in which there's a lot of money to be made. You don't want to miss out on the rally, and the way you can make sure you don't is by looking at the actual composition of the rally, not the hype, and figuring out which stocks will participate in it based on their fundamentals.

This rule came out of one of my biggest mistakes -- and also one of my best calls ever. On June 22, 2005, I predicted a major tech rally in the fourth quarter of the year that would probably spill over into the beginning of 2006. I was right generally: there was a big rally within the tech sector over that period of time. But I didn't pay enough attention to the details and probably ended up causing a lot of people to miss the biggest moves of the rally.

That happened because on June 22, the same day I called the rally, I wrote MSFT, the symbol for

Microsoft

(MSFT) - Get Report

, and CSCO, the symbol for

Cisco

(CSCO) - Get Report

, on my hands. I recommended these stocks not because I thought they were great or even good, but because I had so much conviction in the tech rally that I thought even laggards like Microsoft and Cisco would perform.

That was a serious mistake. Tech isn't a single continuous sector. Many tech stocks have nothing in common with the rest of the sector. It's not like the automobile sector where, at the end of the day, everything in it has something to do with cars. Tech has big, important subsectors; the stocks in the tech sector aren't there because their businesses are related. They're there because they sell either products or services that have been branded "technology." It's a confusing way to group stocks, and it even tripped me up.

If you look at the time frame of the tech rally, which I said would occur mostly in the fourth quarter of 2005, but could also stay strong into 2006, Microsoft and Cisco were both disappointing picks. On June 22, when I wrote its ticker symbol on my hand, Microsoft was trading at $25.07 a share. Cisco, on my other hand, had closed at $19.20. Fast-forward to the peak of the rally, which occurred almost exactly where I called it, on February 1, 2006. Microsoft closed that day at $28.04. That's more than an 11-percent increase from where Microsoft closed on June 22.

At first glance that looks a whole lot better than a sharp stick in the eye. Cisco was at $18.53 on February 1, roughly a 3.5-percent decline. If you looked at just these numbers, you'd think I was right to recommend Microsoft and that backing Cisco was at worst a minor mistake. But remember, we're dealing with a rally, and you have to compare these two stocks to the stocks that actually participated in the Cramer tech rally. If you saw the writing on my hands you probably bought Microsoft or Cisco instead of a much better stock.

Microsoft and Cisco were huge mistakes if you consider the opportunity cost. For example,

Broadcom

was at $36.43 on June 22 and $68.33 on February 1, an 88-percent gain.

Marvell Technology

(MRVL) - Get Report

closed at $39.15 on June 22 and went up 73 percent to $67.70 on February 1.

Apple

(AAPL) - Get Report

went from $38.55 to $75.42, a 96-percent increase. Even if you look at a less impressive performer like

Qualcomm

(QCOM) - Get Report

, which went from $34.92 on June 22 to $47.93 on February 1, you're still dealing with a 37-percent gain.

In light of these numbers, Microsoft and Cisco were both mistakes of the highest order, because owning them prevented you from making big money in other tech names.

What did I do wrong, and how can you stop yourself from making the same mistake? I didn't make sure the stocks I was recommending were actually levered to the rally when I told you to buy Cisco and Microsoft. I painted with too broad a brush. The rally in "tech" that I'd called was actually a rally in gadgets and the companies that make gadget components. It was an iPod, cell phone, PlayStation Portable, Palm Pilot, BlackBerry rally, a gadget rally. And I knew that when I declared the rally on June 22 because I said the rally would be driven by tech product cycles.

These gadget companies all have their own product cycles, cycles that would be moving up toward their peak in the fourth quarter of 2005 and the first quarter of 2006. The gadget makers were coming out with new devices, and they were set to move a lot of merchandise. I knew this was a gadget-driven rally, but I still wrote MSFT and CSCO on my hands for emphasis, be-cause I believed that strength in one part of tech would lead to strength in all parts of tech. It turns out that a rising tide does not lift all ships.

If I had known about this rule when I announced the arrival of the Cramer tech rally, I would have made sure to figure out the precise cause of the rally and then looked over all the stocks I was talking about to be certain that they were levered to the thing causing the rally: product cycles in high-tech gadgets.

Cisco, which makes networking gear, had no exposure to the actual cause of the rally. Microsoft had some exposure to the rally, because its operating systems are in some phones and handheld devices, but it was barely a participant. I should not have written either of these names on my hands, because even though they're generally seen as representing "tech," they weren't levered to gadget product cycles and thus weren't part of the rally.

Especially when there's a lot of money to be made, but even when there isn't, you need to know what you own and why you own it. The Street can be dumb, but it's not so dumb that it will mark up stocks that appear to be associated with a rally but actually aren't. As long as you pay careful attention to the reasons why your stock should go higher, and you make sure those reasons make sense, you won't miss out on another opportunity like the Cramer tech rally by buying the wrong stocks.

Editor's note: This is one of Jim Cramer's 10 Rules from New Mistakes, New Rules: Ten Lessons From My Bad Calls, a special excerpt from his newest book,

Jim Cramer's Mad Money: Watch TV, Get Rich

, in stores now. Check back tomorrow for a new excerpt.

From Jim Cramer's Mad Money by Jim Cramer. Copyright

2006 by Jim Cramer. Reprinted by permission of Simon & Schuster, Inc.

At the time of publication of this excerpt, Cramer was long Marvell.

Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for

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