This week’s grand compromise on tax cuts and unemployment benefits between the president, Democrats and Republicans may not have fully satisfied their constituents, but it was an early holiday gift to investors, and especially followers of this column. The news pushed all the market averages higher and put the Nasdaq Composite above 2600 — my target for taking some profits.
Twenty-six hundred on the Nasdaq represents about a 25% rise from a July trough of 2092, the index’s most recent low. The Common Sense system, which aims to buy lower and sell higher, calls for buying at intervals of 10% in the Nasdaq Composite, and selling after 25% gains. I acknowledge that this is a form of market timing, an approach that seems to be gaining ground among many institutional investors, who seem to prefer the euphemism “dynamic asset allocation.”
Call it what you will, a 25% gain in a major average is a cause for celebration, and seems especially welcome after what has been a challenging and often discouraging two years in the markets. There’s a popular and largely unquestioned adage that what drives investors are fear and greed. I don’t entirely agree. How about their much more benign counterparts, gratitude (when stocks have gained) and opportunity (when they have fallen)?
Fear and greed are the emotions that get in the way of successful investing. At times like these, the greed fostered by a soaring market causes investors to stay with stocks — even to increase their allocations — when they should be cutting back, even if it’s a simple matter of re-balancing. Even a less pejorative emotion, like euphoria, can have the same effect. There’s no pretending we don’t all feel these things. The trick is to separate our feelings from what should be rational decisions about buying and selling, which is what the Common Sense system aims to do.
On Tuesday, when the Nasdaq first pierced the 2600 level, the selling opportunity didn’t last long — all of a few hours. I was traveling, and by the time I was in a position to do anything, the markets had reversed and the index had dropped below the threshold. No matter. The Common Sense system isn’t meant for people who are glued to the market. On the contrary, it’s intended for the vast majority of investors who have other careers and lives. I’d consider the system a failure if it turned all its adherents into obsessive market-watchers. I have learned over the years that there is always another selling opportunity. In this case, it reappeared the next day.
Selling something now also doesn’t mean that the market has hit a peak and will now drop 10% or more. The system doesn’t pretend to identify market tops and bottoms, which is impossible. The market may well mark another 25% gain, in which case I will take some more profits. I never try to predict where the market is going, which is unknowable. I am simply acknowledging where it has been. But for what it’s worth, my long-term view is bullish. [[[LINK: /investing/stocks/was-thursdays-rally-just-the-beginning/]]]. The tax compromise strikes me as one of those instances where the much-maligned party system has worked quite well. From the Republicans we get lower taxes, which are a form of stimulus, and from the Democrats we’re getting extended unemployment benefits, which are another form of stimulus. Add that to Federal Reserve chairman Ben Bernanke’s quantitative easing, and you’ve got a recipe for higher stock prices, at least until the time when the bill or all this comes due.
Selling thresholds always pose the question of what exactly to sell. I’ve learned over the years that deciding what to sell is no easier than deciding what to buy. My default position is simply to sell a broad index fund, like the SPDR S&P 500 Trust ETF (SPY) or the PowerShares QQQ Trust ETF (QQQQ). If you own call options on any of these (I own options on the QQQ), or any other call options, it’s a good idea to reduce leverage by selling those. Given that the goal of my system is to sell higher, it’s tempting to sell some stocks with big gains. They’re definitely a good place to start looking, although there may be good reasons for those gains. It may also be prudent to sell some losing positions, especially with the end of the year approaching and an opportunity to realize some tax losses. A stock price being high or low doesn’t necessarily mean it’s over- or under-valued.
I’ve found the best approach is to look through your portfolio and see if your original investment thesis still makes sense. Why did you buy a stock to begin with? If those conditions no longer apply, it makes sense to sell. This approach brought me to one of my best-performing stocks, the high-flying Chipotle Mexican Grill (CMG). Chipotle was one of the stocks I recommended (and bought) in February, when its price was $100.65. This week it was at $240. Its stock chart looks like a rocket trajectory. It now trades at a forward price-to-earnings ratio of 44, twice the industry average. And that industry is casual restaurants. Although sales and earnings have been strong, this is a trajectory that can’t continue forever. I enjoy eating at a Chipotle from time to time, and I still love the concept. That doesn’t mean I still need to own the stock. My profits from this trade should pay for meals there for the foreseeable future.
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