3 rules for buying stocks in a hot market

With the market trading near long-time highs, is it too late to buy into the rally? Not if you follow these simple rules from a proven pro.

By MSN Money Partner Jul 31, 2013 10:19AM

Image: Arrow Up © Nicholas Monu, iStock Exclusive, Getty ImagesBy Michael Brush, MSN Money

 

With the Nasdaq ($COMPX) hitting 12-year highs, I'm sure I am not the only one wondering: Is it too late to move money from cash to the markets?

 

No, as long as you follow a three basic rules.

 

Namely:

 

1. You wait for pullbacks to buy stocks -- and significant pullbacks will happen.

 

2. You buy the right kinds of stocks for the environment ahead.

 

3. You avoid bonds.

 

That's the big picture take of James Paulsen, a market strategist and economist with Wells Capital Management who has made several good market calls in my MSN Money column since late 1999 when he offered some unusual, out-of-consensus advice. Back then, he was almost alone in saying sell tech and buy bonds -- which turned out to be exactly the right thing to do.

 

Paulsen's reasoning now: The market has moved up so much this year that it will take time to digest the gains. Yet an ongoing, steady flow of reasonably good news on the economy will limit corrections -- making the pullbacks buyable. Meanwhile, concerns about interest rates rising and the Federal Reserve "tapering" of quantitative easing stimulus efforts will limit rallies -- so you don't have to rush to buy stocks today.

 

Ultimately, though, Fed tapering will be good for stocks. It will reassure investors and business leaders, who still wonder what the Fed knows that they don't know -- given the Fed's continued stimulus policies despite the relatively strong economy. In the first six months of this year, the economy grew by an annualized 3.1%, if you take out the effect on GDP of the contraction in the government.

 

"For the rest of this year we will be in the process of debunking the great Fed myth that the market is on a sugar high, and as soon as the Fed pulls away, stocks will fall," says Paulsen. During this time frame, big selloffs in stocks will be unlikely because "the negative impact of rising yields will likely be tempered by economic growth which proves stronger than most now anticipate," says Paulsen. 


What about 2014, then? If his scenario plays out, investors and decision makers at companies will gain confidence. This would lead to more investment in business, setting the stage for another leg up in stocks in 2014. "The actions of the Fed yell every day 'We are very scared and you should be too.' And that has held back business investment," says Paulsen. "In our view, the best way the Fed can boost confidence is by showing some themselves."

 

The outlook this year

In the meantime, this year the S&P 500 ($INX) will trade in a range, roughly speaking, of 1,550 to 1,750, predicts Paulsen. "Economic reports are going to be too strong to allow the market to go down much. But rates are going to be going up too much too fast to allow stocks to go up much," he says.

 

Rising interest rates won't be bad for stocks in general, because rates will be going up for the "right" reasons -- that is, growing confidence in the economy as opposed to fears about inflation. (Inflation fears often foreshadow the end of a stock and economic rally, as the Fed tightens to avert excessive price increases.)

 

But rising rates won't be neutral for all stocks. Historically, dividend payers like utilities, real estate investment trusts, mature companies that produce a lot of cash, and telecom names, lag when rates rise. So do defensive sectors like health care and consumer staples. In contrast, economically sensitive, or "cyclical" sectors like tech, materials, energy, industrials and consumer discretionary stocks outperform. So do small caps.

 

The key takeaway here: "if you are already overweight stocks, I would not be adding money. On strong days, I'd cut back on dividend stocks and defensive stocks. On weak market days, I'd add to cyclical stocks." But if you are underweight stocks, buy in the right sectors on days the market is weak, and roughly anywhere under 1,650 for the S&P 500.

 

Finally, lighten up on bonds, if you have not already done so. Bond prices sink as interest rates rise. And both of these trends are not over yet.

 

Michael Brush is an MSN Money columnist and the editor of Brush Up on Stocks, an investment newsletter.


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9Comments
Jul 31, 2013 1:45PM
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Thank you for some clear how to advice. A nice short, clear and to the point article. It is up to the readers to digest it and act as they see fit.  I wish all the gurus would write this way.
Jul 31, 2013 2:06PM
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Good advice, Michael.

And well written.

Jul 31, 2013 1:58PM
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The USA will never see / experience the real boom type of economy that we enjoyed in the 1980 through 2001. Our standard of living is changing and it is changing where it is going down. There are nor will there ever be again high paying manufacturing and material processing jobs in the USA. Our total buying power is going to be much less than our past buying power.

 

We are no longer a world provider of goods and services. Most countries can now do what we use to do and do it cheaper because they are still in their infancy.

 

Because of the above our stock markets and other investments will continue to not reflect nor measure the health of the economy  as it did in the past. What impacts our future stock markets are going to be very different than what we are use to today and, we are seeing this some what today. .

Jul 31, 2013 1:34PM
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Thanks for the guide and the picture of the market .  But it is a little late though.  I missed the ride of this fed pumped balloon.
Aug 1, 2013 7:10AM
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If you waited for pullbacks to buy a lot of good stocks, you ended up passing them up or paying much more.

The main rule is to pay a price low enough that the stock has a good chance of rising.  Since no one has ever demonstrated the ability to call market tops or bottoms at a rate greater than coincidence, waiting is a loser's game.

For example, Facebook finally broke through the $38 IPO price.  If you want it do you wait for it to pullback?  It may not pullback until it's well into the $40's.  But if you've analyzed all the applicable information and think it will pay off, NOW is the time to buy.

There are various ways of analyzing.  One is to divide the % Projected Growth Rate by the P/E and any stock greater than 1 is a buy.  Another is the Ben Graham formula that the stock's:
Intrinsic Value (max. price to pay) = EPS x (8.5 + 2 x % [Projected Growth Rate]).

Both of those might be used as screens, but they are not sufficient on their own to determine good stock prospects since Projected Growth Rate is often WAY overestimated, further research needs to be done.  How consistently and at what rate has the company increased earnings in the past?  Has to company shown an ability to put new earnings to work?  Does it pay a dividend and raise it consistently?  Does it have a lot of Long Term Debt?  Is there a new competitive threat on the horizon? Etc.

Jul 31, 2013 3:03PM
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Tapering and ending will happen when it is prudent to do so...
Jul 31, 2013 12:42PM
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No, as long as you follow a three basic rules.

 

Namely:

 

1. You sell all your stocks and bonds forcing corruption to implode on it's own criminal activities.

 

2. You quit your job, forcing hired-in management to buy you back for ridiculously more than you earn now.

 

3. You join the 83% of America that wants to impeach the whole government, close the banks, end the Federal Reserve and to get rid of Wall Street.

Jul 31, 2013 12:38PM
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The REAL headline for this article should be: Fed Buying Another Record High As It Fakes Recovery and Funds Global Financial Terrorism.

When do we get genuine reporting instead of this Kool Aid?

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