Build Positions Gradually

The following is from this morning’s Kelly Letter sent to subscribers. Because of the recent volatility in the market, I decided to publish it publicly as well. To see what the letter is actually buying, please sign up for a one-month trial.

I’ve been writing for half a year or so that the financial crisis would not end until some banks fail. With Bear Stearns’s bailout last week, we’re entering that stage.

Technically Bear didn’t fail, but that’s because of the bailout. It’s on life support from JPMorgan and the New York Fed, and that’s close enough.

Notice that I wrote “we’re entering that stage” as opposed to “we’ve hit bottom.” A bottom is a process, not a point in time.

People have been talking about a double bottom in the market but what they’re leaving off is the final phases of a true double bottom. We don’t know yet if we’ve made one.

A double bottom pattern has six points. They are:

1) The first low (Jan. 22 at S&P; 500 1,310)

2) The turn down from overhead resistance (Feb. 1 at 1,395)

3) The support test near first low (Mar. 10 at 1,273)

4) The initial surge higher (Mar. 11 to 1,321)

5) The follow through back up to overhead resistance (not yet)

6) The breakout through overhead resistance (not yet)

As you can see, we’re missing a third of the process needed to call this a successful double bottom. The S&P; 500 needs to close above 1,400 before we can be confident that it’s heading higher for real, according to the double bottom pattern.

There are other ways of viewing the market. I’ve written about MACD and relative strength before, both of which I’ve found to be helpful in timing.

On Jan. 22, the S&P; 500’s MACD was -35 and its relative strength was 26, both showing extremely oversold conditions and a market ready to bounce. It did.

On Monday, MACD hit -18 and relative strength 31, both low but not as extreme as in January. At the end of last week, MACD closed unchanged at -18 and relative strength a little higher at 39.

These measurements are unclear because we don’t know if they never got low enough for a true washout and are just fluttering in a range, or if Monday was the washout and now they’re turning higher as the market follows through on its way back to resistance. Sometimes these don’t give a clear buy signal even when it’s a good time to buy.

One factor that’s screaming to buy now is sentiment. I’m a believer in sentiment gauges as I tend to be a contrarian in all walks of life. I drive roads few people know, I go to amusement parks and other public places on weekdays in the off season, I buy winter clothing during spring clearance sales, and I tend to buy stocks when others are panicked and sell them when others are euphoric.

These days, people are panicked.

Bill Luby at VIX and More showed Friday that the ratio of the VIX to the yield on the 10-Year Treasury Note “is currently at levels seen only during extreme crisis or panic market environments.”

SentimenTrader examined other times when the ratio has been at current levels and found that the S&P; 500 rose an average of 2.0% in the next 5 days, 3.7% in the next 10 days, 4.2% in the next month, and 10.6% in the next 3 months.

The percentage of times that each time frame registered a gain instead of a loss was impressive, too: 85% of 5-day periods, 92% of 10-day periods, 77% of 1-month periods, and 92% of 3-month periods.

Here’s what all that tells me:

> Don’t short, don’t hedge.

> Don’t sell what you already own.

> Look to buy during this time.

The reason I can’t say to just wade right in and buy with all you’ve got is that we don’t know how many more Broken Bears are waiting in the wings. We’ll probably see more big trouble in banks. Will that tell investors that we’ve finally seen the worst, or that they need to brace for more?

I would feel much more comfortable buying now if we’d seen a selling climax to an even lower level on huge volume, extreme readings on the MACD and relative strength, and a few more big bank failings. It seems that all of that could lie dead ahead, and that the difference between buying now and buying in a couple of weeks could be significant.

The best way to take advantage of the search for a bottom is by moving gradually. Buy in thirds if you’re nervous, in halves if you’re not. If you want to own 150 shares of something, buy 50 now, another 50 later, and the final 50 after that. It’s a way to feel good no matter how events unfold.

A fact to keep in mind is that nobody can say the day the market bottomed until well after it’s behind us. To take advantage of market bottoms, then, it’s necessary to either be a little early or a little late. If you have the stomach to fall before rising, then a little early is fine. If you won’t tear your hair out by missing some of the early gains, then a little late is fine.

Only you can know your own feeling in that regard. It’s important to accept ahead of time, however, that you will not buy at the exact bottom. The best you can do is get close and what you need to decide now is what way of getting close works best for your personality and portfolio.

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