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Buying high, aka upside capitulation

By Dr. Don Taylor ·
Tuesday, November 12, 2013
Posted: 1 pm ET

Capitulation happens in the financial markets when investors throw in the towel and sell their investments. They typically move to cash (money market holdings), sitting on the sidelines waiting for the best time to get back into the market. This is known as "selling low."

Upside capitulation is when investors get sick of sitting on cash and watching markets head higher, sell their short-term holdings and buy into the market. The risk of upside capitulation is that you get back into the financial markets just before prices start to head south. This is known as "buying high." Retail investors are notoriously poor market timers, accused of combining these two capitulations and buying high and selling low.

Don't be that investor.

One way to try to minimize upside capitulation is to "buy on the dips." The investor hopes that there's no trend reversal and that markets continue to trend higher and the dip is a buying opportunity.

I did this myself this summer. I had some retirement money sitting in a short-term bond fund, not quite cash but close. I wasn't comfortable in longer-term bonds because I expected interest rates to head higher, and when interest rates go up, bond prices go down. When the year-to-date return on my short-term bond fund turned negative because of rising interest rates, that was my impetus to look at finding a new home for this money. I set a target for the Dow Jones Industrial Average of 15,000 and bought into the U.S. equity market when the Dow dipped below that number.

Dow: Not a great barometer

The Dow, as a price-weighted index of just 30 stocks, probably wasn't the best choice of an index to use in looking for a dip, especially when my plan was to invest in a broad market stock index fund, but that was my target. It worked out for me that time, but there's no guarantee that it will work the next time -- for me or for you. That's because at any point in time we really don't know where markets are headed next.

Investors typically have basic asset allocations divided among stocks, bonds, cash, real estate and alternative assets. When the U.S. market has experienced investment bubbles over the past two decades, investors have found reason to over-allocate investment in stocks and real estate. In the late '90s everyone wanted to be in stocks. In the mid-2000s, it was real estate. Since the financial downturn in 2008, stocks have recovered to record levels in most of the major U.S. indices.

Rebalance your portfolio

The trailing stops that I discussed in last week's post can get investors out of a stock when the music stops. Periodically rebalancing your portfolio can get your asset allocations back in line with your targets, which should mean that you're lightening up on your winning sectors and reinvesting in the underperformers that might have more upside potential in the future. Don't forget to consider and manage the tax implications if you're doing this in taxable accounts.

I want to circle back and discuss the whole idea of money on the sidelines. In the financial marketplace, there is someone on the other side of every trade. If I sell 100 shares of stock at $50 per share, I've freed up $5,000 in cash, but the person on the other side of the trade has invested $5,000 in cash. Net cash on the sidelines from trading stocks is $0.

Cash on the sidelines is more of a monetary policy issue. As the Federal Reserve pursues an easy money policy with a low targeted federal funds rate and quantitative easing, this keeps liquidity in the system. With the low interest rate environment in both the money market and the bond market, this liquidity is finding a home in the stock market, bidding up stock prices.

The eventual reduction of U.S. Treasury purchases of mortgage-backed and Treasury securities should reduce the demand for stocks. Current expectations have the Fed starting its tapering in 2014 or beyond, depending on economic conditions and U.S. unemployment levels. The Fed decision not to taper in September 2013 and reaffirmed in its October meeting is one possible explanation for positive U.S. equity returns in both months.

What do you think? How do you keep from being the investor that buys high and sells low? Will the Fed not tapering keep the music playing for the stock market? Will political shenanigans resurface with budgetary issues and debt ceiling constraints, resulting in the derailing of financial markets?

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