How to Use Pullbacks for Profits
The news headlines weren’t pretty to start the week.
Monday’s 726-point drop in the Dow Jones Industrial Average was its worst day since October. The Russell 2000 Index of small-cap stocks briefly touched correction territory — down over 10% from the high. The 10-year Treasury yield plunged to 1.17% on safe-haven buying.
Many blamed the spreading coronavirus’ Delta variant for the sudden nosedive in stocks.
But the stock market was already deteriorating well ahead of this sell-off. In fact, I’d argue that most stocks actually peaked months ago.
Check out this chart of the S&P 500 Index compared to the Russell 2000 Index. Small caps have trailed large caps by about 15% in the past four months!
So, despite the sudden plunge in large-cap stocks, smaller companies have been struggling for some time now.
And honestly, you should welcome this pullback.
We were long overdue, as Ted noted in this week’s Bauman Daily, and stocks need to hit the “reset” button to clear out speculative excesses.
Here’s what you should — and shouldn’t — do now.
First off, don’t panic!
Stock market pullbacks are normal. The S&P 500 sees at least two 5% pullbacks every year on average.
So, don’t be tempted to sell all of your stocks and run to cash. And absolutely do not try to time the market. Not only is it impossible, but you risk doing serious damage to your returns over the long term. Just consider this…
A recent study showed that over the past 20 years, the S&P 500 has averaged an annual return of around 6%. But if you missed the 20 best days for gains, your returns would fall to 0.1%.
Instead, what you should be doing is regularly booking profits as the market marches higher. That frees up capital to allocate to other positions in the future, which leads to my next point.
Be the Opportunist
Next, be opportunistic when the stock market turns lower. Use that cash pile from harvesting gains to add new positions … or increase existing positions that have pulled back.
That’s especially true when you see signs of market capitulation, which is what Monday’s collapse looked like. By becoming familiar with metrics such as market breadth and investor sentiment, you can know when the weak hands have thrown in the towel.
Let me give you an example…
The chart below shows how many stocks are trading above their 20-day moving average. On Monday, that figure stood at 15%, meaning 85% of all stocks were in short-term downtrends, pointing to extremely oversold conditions in the market.
These points of capitulation are often the most difficult time to buy, because stocks are in free fall. But that’s how you can turn investor panic into terrific opportunities to buy at bargain prices.
Since Monday, the S&P 500 has already rebounded more than 2%.
So, stay smart and tough, and don’t get shaken out of this market! Stick to your game plan. That’s how you will generate profits over the long term. The Bauman Letter’s Endless Income portfolio sticks to its plan by discovering terrific opportunities to grow your income. And it’s beating the S&P 500 by 15% on open and closed positions.