How to profit from bear market panic

Bear markets invoke widespread panic among investors, often stampeding them to sell all the stocks they hold. Intelligent investors who can, however, calmly select which stocks to hold on to are rewarded with great profits once the market turns back up.

In any assessment of holding versus selling stocks, you should first understand the circumstances under which it is best to sell.

You should hold a stock only if it does not fail any of the tests for selling.

This is true in all circumstances, not merely during market downturns.

16 triggers for selling

The company-related reasons to sell are:

Sell if the news cannot get any better.
Sell if things did not go as planned.
Sell when the broker's advice goes from 'buy' to 'hold'.
Sell if company fundamentals are getting sick.
Sell on the rebound in the aftermath of material, unexpected or discrete bad news.
Sell in certain cases when expected news is delayed.

The market-action reasons to sell are:

Sell when the stock reaches the target.
Sell on an unsustainable upward price spike on big volume.
Sell when a portfolio shows all gains.
Sell if the stock is lazy money and likely to stay that way.
Sell using above-market limit orders, letting the market come to the investor.
Sell with a stop-loss order, but never remove or lower it.

Investor-related reasons to sell are:

Sell if you would not buy the stock again today.
Sell after gloating or counting the chips.
Sell rather than hope against hope for a 'maybe' bailout.
Sell and step aside on a personal losing streak.

If you regularly sell stocks in a disciplined manner, say after periodic 6-monthly reviews using the signals above, you are likely to end up with a good deal of cash even before the market moves into a bear cycle. Relatively few of your holdings will survive the 16 triggers noted in the lists above.

Those stocks that do survive will tend to be high-quality growth issues that have continued to perform fundamentally and have not run up to unreasonable price levels. Some experts refer to these as core holdings or 'businessman's-risk' foundation stocks. They are stocks that have given consistent indications they can be held through good and bad in the market.

So if you are periodically reviewing and cashing in as prescribed, and if your buying discipline rejects new positions when valuations get too pricey, you will anyway end up holding only relatively few stocks as the market gets toppy - and even before it turns down. That, of course, protects your capital.

Which stocks to hold for great future profits

Looking at stock price trends not from a mechanical view point but from a big-picture perspective, there are two major price driving forces:

Fundamentals (which control the long term), and
Psychology (which rules the short and medium term).

The fundamental and psychological factors affect stocks in both directions. And as an overlay, understand that they can affect a stock either directly - because of the company behind the stock itself - or indirectly - because the market trend is so strong that virtually no stocks can buck it. However, the indirect effect is much stronger on the downside than on the upside: fear is invariably a more powerful driver than greed.

The central concept to grasp is the occasional need to play even when it is painful. But this concept applies only and specifically to holding stocks that are being affected essentially by the overwhelming negative psychological forces that occasionally cause selling routs or panics in the market as a whole.

To put this very important limiting caveat another way: when a crash or panic occurs, stocks should be held only if they are going down because of market factors and not if they are being affected by company factors.

Appropriate pre- or early-bear phase selling should have left you with only a few, high-quality stocks. You can and should hold on to the gems and play through the difficult experience of a panic or crash. You will be holding only a relatively small portfolio (having followed the 16 stock selling triggers well before the bottom nears), so your level of pain will be no worse than moderate. And your cash holdings will give emotional comfort and provide the resources for acquiring stocks advantageously when prices get really low.

Some investors may see a contradiction in this advice because they are typically counseled that avoiding losses is the first priority and the best reason for selling. But taking a short-term dose of paper losses in a crash - by holding quality issues - is a lesser risk than selling out during the fury, and hoping to have the courage and good executions to get back in at lower prices shortly afterward.

If an investor is down to just a few core holdings anyway, he is better advised to tough it out. The very experience of playing in pain through a temporary crash is also of enormous instructional value despite the modest monetary cost involved. The process of crisis thinking and the need to make wrenching decisions that prove valid in short order will serve him well for the rest of his investment career.

When caught in a panic, the central question to address is whether capitalism in the United States and major world free markets will continue to function after the panic ends. If the answer is yes, then there is no reason to sell at foolish levels. In fact, the only rational thing to do is take courage and make buys. Being gutsy enough to act on the contrarian test - refusing to sell good stocks cheap because Wall Street and Main Street have lost faith for a few days - ensures great profit after the panic subsides.

(Excerpt from It's When You Sell that Counts by Donald L. Cassidy, a cum laude graduate of the Wharton School of Finance and Commerce at the University of Pennsylvania, USA and an analyst with Lipper Analytical Services)

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