Finding the Upside in an Up-and-Down Market

Here's a strategy for profiting from recent stomach-churning volatility.
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It's been tough to make a buck in this market.

On Feb. 1, when I toted up the performance of

Jubak's Picks, I showed a gain of a whole 1% for 2000 to date. But what a ride I "enjoyed" to get that single percentage point of return! The

Nasdaq Composite

, the index I use to benchmark my technology-laden portfolio, started the year at 4132, fell 10% to 3727 by Jan. 6, recovered to set a new high of 4235 on Jan. 21, then tumbled 8% to 3887 before rebounding on Jan. 31 and Feb. 1 to close at 4052.

Well, get used to it. I think this stomach-churning volatility is pretty much what investors can expect for the next five months or so.

This is typical for a market that's trying to decide how many times the

Federal Reserve

will raise interest rates and by how much each time. In January, every economic report or analyst pronouncement suggesting that the Federal Reserve would tack on more than a token 25-basis-point increase at its February Open Market Committee meeting sent the market down. Every time investors decided that 25-basis-points-but-no-more was the likely scenario, the market rallied.

This is pretty much the scenario that my Jan. 11

column, "A Strategy That Lets You Sleep at Night," was designed to address. I still think my steps 1 and 2 in that article -- selling individual stocks that show signs of increasing risk, and selling weaker portfolio stocks into rallies to buy lower-risk, higher-potential stocks on the dips -- should be enough to handle market risk this year. (It's because of those rules that'll I'll be selling

Advanced Fibre Communications

(AFCI)

with this column. You can find more details at the end of this article.)

But this volatility is going to last longer than I thought just a few weeks ago. And I think that this change requires some strategic fine-tuning. I'm adding a fourth step to the three steps in my Jan. 11 strategy. Let's call this fourth step "Act short term, plan long term."

In the rest of this column I'll explain why I think a fourth step is needed now, then explain the way this step works and finally give you a calendar that will help you to apply it in 2000.

The Fed's Not Done Yet

I no longer think there's any chance that the Federal Reserve will be clearly done raising rates by its March 21 meeting. Stronger-than-expected economic growth in the fourth quarter of 1999 of 5.8% raised the possibility that the Fed might increase rates as many as three times in 2000. I'm even starting to see market analysts make comparisons to 1994, a year when the

Alan Greenspan

-led central bank followed three 25-basis-point increases with three 50-basis-point increases and a 75-basis-point rise.

Influential investment houses such as

Goldman Sachs

and

J.P. Morgan

are predicting rises of 75 or even 100 basis points this year. At a minimum, we'll be watching the Fed with bated breath until the bankers finish their June 27-28 meeting. So the uncertainty that led to so much volatility during the buildup to this week's 25-basis-point increase in the

federal funds rate

is going to be with us in the weeks before the March 21 meeting, the May 16 meeting and the June 27-28 meeting.

The duration of this volatility alone can change the tenor of this market. After the second near-10% drop on the Nasdaq in January, I started to see a smattering of emails and posts on the "Market Talk with Jim Jubak" community from investors who had had enough. One 10% drop hadn't scared them, but two so close together had. And they were pulling all or at least a substantial part of their capital out of the stock market. They'd wait -- as one email put it -- until things settled down.

Imagine, then, how unsettled a larger number of investors will be if February and March and April are this volatile as well? The likelihood is that after each drop, more folks will decide to move to the sidelines.

Volatile Market Gets More Volatile

The history of other periods of volatility shows that some of these investors don't stay on the sidelines for long. They move back in quickly when the market rallies. But their faith has been shaken and they move to the sidelines even more quickly at the next sign of downside volatility.

This behavior explains the tendency of swings to the upside and downside to get more extreme as a period of volatility lengthens. With each drop, more investors move to the sidelines more quickly. With each rally, investors pile in more quickly to take advantage of short-term bargains, but lacking conviction, they jump out ever faster at the first sign of the next dip. This raises the possibility that some downward move late in the cycle may be sufficiently frightening to enough investors that it leads to a true correction. At the same time, the duration of each swing decreases as investors move out and in and out again more nervously. The rallies -- and the declines -- get bigger

and

faster as the period of volatility stretches out.

(I think a real correction is unlikely as long unless the Federal Reserve steps on the brakes so hard that it wrings growth out of the economy altogether, by the way. But if profits start to fall, then indeed all bets would be off.)

What can investors do about this?

Trading in a Rocky Market

You could try to trade such a period. It's sure got the huge rallies and big dips that fuel trading profits. But such periods are also notoriously difficult to trade. The moves are big, true enough, but the market is essentially trendless, making it hard to predict from day to day if the next move will be up or down. The speed of the drops and rallies makes timing entries and exits accurately absolutely critical if an investor would like to see any profit at all. And figuring out good entry and exit points is difficult since, thanks to the steadily increasing volatility, individual stocks will often violate seemingly solid support and resistance levels. Most investors who have just started trading in the last year or two, and who may have made huge profits in 1999, don't have the experience to navigate such a market. They ought to sit this one out until the trends are easier to read.

Some investors with longer time horizons will probably decide to sit this period out as well. That's understandable. The volatility is scary, and the net gain during this period for any of the major indices is likely to be pretty small. Investors who know they start to feel panic when a position is down 10% or more in a few days should move some money to the sidelines during a period like this, using the steps I laid out in that Jan.11 strategy column. It's extremely hard to make money when you're worried about showing a loss all the time.

There's a third alternative, too, one that tries to use the short-term volatility to long-term advantage. This tactic, which I called "Sell short term, buy long term above," builds on the idea of single-mindedly eliminating weak stocks from a portfolio by selling them into rallies. But instead of buying to upgrade on a case-by-case and moment-by-moment basis, "Sell short term, buy long term" recommends preparing for a period of volatility by putting together a list of key stocks that you've identified for their potential during the second half of 2000 and beyond. An investor would spread buying those stocks over the entire period of volatility that I think is likely until June.

For it to work, an investor has to follow both parts of this step and prepare for both steps in advance. The market is so volatile, you won't have a chance to research stocks after you recognize a buying dip or a selling rally. Nope -- you've got to have your list of sells and buys ready ahead of time.

For example, right now in Jubak's Picks, I'd identify Advanced Fibre Communications,

IBM

(IBM) - Get Report

and

Vitesse Semiconductor

(VTSS)

as potential sells into rallies. (With this column, I'm selling Advanced Fibre into the post-Federal Reserve meeting rally, and I'm holding IBM and Vitesse temporarily to let their prices move up a bit further in the next couple of weeks.) In another, less-volatile market, I'd probably hold onto all three of these stocks. They've been disappointing lately, but there's nothing horribly wrong with any of them.

But a volatile market highlights the flaws in the growth stories of each of these stocks -- in the last quarter, there's been some glitch in revenue growth at each -- and creates potential bargains in better stocks. To strike quickly if those bargains materialize, I'll need ready cash. In a nutshell, I'm selling stocks like these because I think the market's volatility will give me a chance to buy better stocks, and I want to be ready.

Decide Potential Buys

At the same time, I'm starting to put together a short list -- five or 10 names at the most -- of the stocks I want to buy on big downward volatility. For Jubak's Picks, which is a 12-to-18 month portfolio, this won't be a list of all-time great stocks that I've always wanted to own. Instead, each stock should be one that I think has extraordinary potential for the second half of 2000 -- because of something concrete I can identify at the company or in its market -- and that I would not buy right now solely because of price. (If I'd buy it at the current price, I ought to buy it rather than put it on a list.) I'm going to spend the next three columns generating names for this list from the Future 50 and 50 Best Stocks in the World portfolios. At the end, I'll have my list of potential buys and I'll be ready to strike when the moment is right.

Getting the moment right during a long period of increasing volatility won't be easy. If the scenario for the period through June plays out as I've speculated, I should wait until as late as possible, since dips will be increasing in size as the period wears on. But markets hardly ever play out according to plan, and the Federal Reserve could always move either faster or more slowly than I expect now. I certainly don't want to see the volatility end with any cash that I've raised sitting on the sidelines.

To help me figure out when to strike, I've put together a calendar for the first six months of the year. Events may not play out exactly this way, but putting together an explicit calendar like this is a good way to check when reality deviates from my underlying expectations. The point of the exercise is not Godlike omniscience, but a useful record of what didn't go according to my projections.

  • Feb. 2: The Fed raised the federal funds rate the anticipated 25 basis points to 5.75% and increased the discount rate 25 basis points to 5.25%. In its "balance of risks" statement, it emphasized the need to head off inflationary pressures. The market, which had rallied ahead of the news, continued to rally the morning after the announcement.
  • Feb. 2-17: Lots of support for technology stocks. A steady stream of brokerage firm technology conferences ( SoundView, Robertson Stephens, Goldman Sachs and J.P. Morgan, among others) gives companies a chance to remind analysts how great their stories are. Earnings from stalwarts such as Cisco (CSCO) - Get Report on Feb. 8 and rising stars such as Brocade (BRCD) on Feb. 17 keep the good news going. All this culminates with the hoopla surrounding the Feb. 17 launch of Microsoft's (MSFT) - Get Report Windows 2000. (Microsoft is the parent of MSN MoneyCentral.) This period should be positive for technology stocks.
  • March 1-21: Rising Fed worries again. Maybe an earnings warning or two to start the jitters, but the burning questions will surround the Fed meeting on March 21. Worry about the possibility of a 50-basis-point increase should produce some spectacular volatility.
  • March 21-April 30: Relief that whatever the Federal Reserve did wasn't worse leads into earnings season. Expect some jitters from this one, too. A lot of companies are facing tough comparisons with great first quarters in 1999. Still, many stocks should have their usual anticipatory ramp as investors buy shares in companies that might beat the consensus estimate. One wild card to watch: the preliminary estimate of economic growth in the first quarter of 2000. Will the economy show any signs of slowing down? Any slowing would be good news for the financial markets.
  • May 8: The Hambrecht & Quist technology conference (now the Chase Hambrecht & Quist conference) traditionally ends the technology conference season. Many stocks will experience significant run-ups in price, setting the stage for the traditional summer slump in technology shares.
  • May 21: The Federal Reserve meets again. With more jitters on interest rates and inflation, but without much to distract investors from mid-May to the beginning of earnings season in early July, worries will have a chance to feed upon themselves. Knowledge that this is an election year and that the Fed won't want to make a big move too close to the election may heighten speculation about the possibility of a big rate increase here.
  • June 15-28:The season for earnings warnings leads right into the Federal Reserve's June 27-28 meeting. A good chance for maximum jitters here. But this is also, in all likelihood, the last meeting where the Fed might increase rates dramatically. The August and October meetings are too close to the November election.
  • June 28 and on: If investors think Alan Greenspan and company are done for 2000, the focus shifts to earnings and revenue growth. Investors may well be worried about growth if the Fed has, in fact, put the brakes on the economy. Stocks that show the ability to grow despite an economic slowdown should do well here and for the rest of 2000.

Or at least that's my best guess right now.

Next column I'll start to put together my volatility "buy" list by looking at the Future 50. (And I'll update the buys on that list as well.)

Jim Jubak is senior markets editor for MSN MoneyCentral. At time of publication, he was long Advanced Fibre Communications, Nokia, SDL, Microsoft and Vitesse Semiconductor, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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