Today's Rally—Yay! Or Nay?

We finally got our relief rally with all of the major indices gaining 11%. The media claims the rally was fueled by worldwide bailout moves from central banks, but this market was so oversold that even a report that Paris Hilton might be retiring from the public eye could have sent stocks soaring. Historically, there is a high correlation between bond-shortened holidays (or in this case, no bond trading) and market gains. Today was no exception.

Now, the question is: Is this just a temporary correction or the beginning of a new bull market? As I mentioned last week, most market technicians (including me) are in the former camp. So, what course of action should we take assuming there's further downside?

Get rid of portfolio crud
This means dumping your dogs. How do you identify a dog? It could be a stock that has been lagging its industry. It could be a company with little cash and a high debt-to-equity ratio. It could be in a sector that is expected to especially do poorly in a recession such as retail and consumer discretionary. It could be a high-risk company--a high-tech infant with a new, untested technology or a biotech with only one product in its pipeline. These are companies to dump and to avoid buying at any cost, at least for right now. Your motto should be: If I wouldn't buy the company now, get rid of it.

Use market rallies to put on portfolio protection and dump your dogs
Looking at the action going into today's close, it appears that the major indices continue to advance albeit on declining volume. This type of action is typically followed by a bullish open on the morrow, so I expect that the market has a few days more upside to it. (The market was so overstrung that there could be a few weeks of gains, but I wouldn't bet on it.) This would be a good time to dump your dogs and protect the rest of your portfolio, if you've been too lazy or too shell-shocked to take action months ago. (See last Wednesday's blog for portfolio protection strategies.)

You own ultrashort ETFs and got hammered today—what now?
First of all, I feel your pain, especially those of you who were in the foreign markets and commodities ultrashorts, some of which lost between 25-45% today. (The EEV, the emerging markets ETF was the biggest loser.) But the incredible gains of last week should have clued you in to the possibility that this situation might occur soon. Okay, so you didn't lighten up or take steps to protect them—now what? I would get out as soon as possible, even if all of your potential profit has been wiped out. Sure, you could hang onto them, but I think that they've got a lot further to fall, and getting back to your break-even level might take some time...if ever.

You'll be able to recoup some of your losses by selling out-of-the-money cash-secured puts when the market looks like it's about to tank again, provided you still want to own the ETF. (See Recipe #6: Put Pot Pie on how to use cash-secured puts to buy stock as well as the attendant risks.) This might ease the pain of today's loss. Remember that the ultra ETFs are double-edged swords!

Note: You can use the cash-secured put strategy on any optionable stock that you wouldn't mind owning. This is one way to generate cash into your account but the major risk to this strategy is that the stock can move below the strike price. While this isn't the best strategy while the market is still trending lower, it is a great one to use at the beginning of a bull market, so keep that one on the back burner.

Update on Friday's Morgan-Stanley Plays
Morgan Stanley sweetened its deal offering which Mitsubishi accepted this morning, one day earlier than expected. (I'm sure that the Treasury Department along with other foreign banks making aggressive moves into their banking systems didn't hurt, either.) On Friday, I mentioned a covered call play that would work if the deal went through and a covered put play if you believed the deal wouldn't go through. If you made a play that the deal would be consummated, then you're probably pretty happy. My suggested covered call play would have returned 100% with 67% downside protection—not bad! However, if you made the opposite trade, you'd be suffering a loss unless you managed to exit the trade near the open (as I advised) in which case you would have broken even. (The trade's break-even point was $15.20.) Had you just shorted the stock, you would have woken up to a nasty loss of $5.75 over Friday's close for an ugly 60% loss!