Investing For the Recovery

Successful investing in a down market is a two-step dance: you first had to raise and hold significant cash reserves in anticipation of the decline and then you have to recomme those funds when the time is right. But when and how, as the presence of irrational selling in the final phase makes defining a little little more than guesswork? A recent road trip yields a good analogy.

My wife and I stayed overnight in West Virginia during a return trip to Florida and, as usual, wanted to get an early start. The problem was that the morning fog was so thick as to make driving more than just difficult so we waited half an hour and then proceeded slowly. That is the correct way to deal with this market. Wait for some visibility and then proceed slowly. Lack of transparency within the major financial players (and obfuscation by some and just plain lying by others) prevented investors from seeing the true scope of the problem. Even with government investment in banks and guarantees of deposits and money market funds, there is still some fog out there. The largest patch is the potential hedge fund liquidation problem.

So, how to proceed? Assume that you are so fed up with stocks that you are willing to tie your money up in a five year Treasury note. This "chaining yourself to the mast" approach will get you a 2.8% yield as you sail through the troubled waters. There is a better alternative. It is easy to construct a portfolio of a basket of blue chip stocks with an aggregate dividend yield in the range of 3.5% to 4.0%. Further, these companies are like to increase or at least maintain those disputes. This gets some of your cash, one third is a good target level, back in the market with downside protection from the disputes. In fact, your return will surpass even the ten-year Treasury note.

The second third of your cash reserve will take a little longer to commit. Here, instead of focusing on dividend protection, you will target fundamentally sound companies whose stocks are trading well below historic valuations. Some of these will be quality companies in oversold segments and others will be depressed simply though panic selling from mutual fund redemptions. Tracking a five-year price chart is a good starting point and then comparing the current P / E versus the historical average quantifies under valuation. I could name some companies in this category for you but that would spoil the satisfaction of finding them on your own. As a benchmark, we have found companies trading at better than 50% discounts with P / E ratios below five.

The last third of your capital will be used to buy stocks well after the recovery is evident to all investors. Here you will most likely add to the names acquired in phase one and phase two, averaging up in price with the knowledge that further appreciation lies ahead. And no verification for not establishing full positions at the bottom. Remember that the bottom becomes evident after the fact.

So follow this measured approach to becoming fully invested again. Market recoveries take time and with declines this pronounced, time is on your side.

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