The one great certainty of the stock market is cycles. There will be ups and downs and bull markets followed by bear markets. The thinking of many market players is that if I hold good stocks and stay patient, then everything will work out in the long run. Good stocks always come back, so there is nothing to worry about.
That may work out in the fullness of time if you are holding the right stock, but if you understand, accept, and embrace the inevitability of market cycles, the flow of good opportunities can be overwhelming.
First, it is important to understand that most severe market corrections occur in a correlated manner, as we saw in 2008-9 or in early 2020 when the COVID pandemic hit. These corrections have little to do with the individual merits of a particular stock. Everything is sold without much regard for what it might be. When someone sells the S&P 500 or the Russell 2000 ETFs, then every stock in those indices is also sold. Thousands of ETFs trade large buckets of stocks, and the good are thrown away with the bad when a correction occurs.
Therein lies the great opportunity of market corrections. Stocks are sold in a lump, and there is no effort to separate out the quality names from the garbage. Charts will help some, but you really need to understand the unique situation of each stock and the fundamentals to appreciate which stocks hold the best potential for strong upside as a market correction comes to an end.
Identifying your targets is the first step in the process. Every day on RealMoney.com, I discuss underfollowed stocks that I believe have something special that will eventually drive them higher. Finding those names and then watching them carefully and learning more about them is the first thing we do.
Once we have found some promising targets, then the job is all about timing and positioning. I typically will take a smaller initial position just to have the stock on my radar. That forces me to watch it closely and to develop a sense of how it trades.
My methodology is to make many buys and sells as the volatility develops, but many of the big winners come when I build larger positions during a period of market weakness.
The biggest problem that traders tend to run into during market corrections is that they already hold too much of their favorite stocks that are weak. They don’t want to buy more and hold an uncomfortably large position, and they don’t want to sell because they have a high level of confidence. It creates a difficult dilemma.
I typically deal with this by setting some tight stops on names that I favor but with a firm plan to rebuy the stock as conditions develop. It isn’t important if I rebuy higher or lower. I want to rebuy when I feel technical conditions are better and I have a higher level of conviction.
One of the great benefits of reducing position size in a stock that you favor is that it shifts your mindset and emotions. Rather than constantly complain about the weak action, you welcome it and view it as a potential opportunity. There is always the chance that you may have made a bad pick, but the reduction of the position size allows you to limit risk until the stock proves itself again.
There are a number of stocks that I favor right now that have been acting poorly. I have cut them some, but my intention is to rebuy them in even bigger size once market conditions look better and potential catalysts approach. I’m watching them carefully and actually take some pleasure when they continue to break support and cause a chorus of complaints.
The cyclical nature of the market rewards those that take a contrary view at market extremes. When the market corrects, it is important to reduce risk, but it is also important to focus on position for the next positive cycle.
Get an email alert each time I write an article for Real Money. Click the “+Follow” next to my byline to this article.