The sharp pullback on the major indices today (Tuesday, November 1, 2011) had at least two clear effects. It added a distribution day to our count that puts pressure on this fledgling rally, and it reaffirmed how news-driven this market remains. I have been writing all year about the need for substantive progress toward solving international and domestic problems. Months of bickering and posturing, none of which has led to action, have only served to keep the market volatile.

 

Today, investors were presented with a tempting opportunity to try to “play catch up” by buying leading stocks at a cheaper price. Buying weakness isn’t always wrong, but it always comes with additional risk. And given how volatile and susceptible this market is to the news of the day, I’d call it extremely risky. No one knows when or if a pullback will stop “pulling back.” From a portfolio management standpoint, buying a pullback when your position (or portfolio) is showing a loss is the same as averaging down. As my father says, “If you aren’t profitable at 10% invested, why go to 20%? And if you aren’t profitable at 20%, why go to 30%?”

 

Having a profit cushion changes the odds slightly and puts you in a better position to take on the risk. Adding to a position on a pullback will always carry some risk, but a cushion allows you to push the envelope a little farther, and wade in a little deeper, while scooping up lower-cost stock. This is what the large operators like to do. Initiating a position on a pullback while your portfolio is up on the year is not recommended. During a past webinar, we discussed this concept in more detail, but essentially buying pullbacks should be an incremental decision, taken only after your previous decisions proved correct.

 

To lower the risk of buying a stock that is pulling back, look for stocks moving down on lower volume or showing spiking demand at logical areas of support on the way down. This is an indication that although the price is falling, the stock is running out of sellers, and the big, institutional investors are moving in to take their place. Several attractive leaders presented enticing pullbacks today. The most promising stocks among them sold off at the open and rallied back—somewhat—to close in the upper half of their intraday range.

 

Lastly, keep in mind that this environment is challenging and unpredictable enough. Anyone trying to play either side of this rally with size is nuts, in my opinion. Remember your portfolio exposure should be a reflection of your confidence in this rally. And you don’t always have to play. Stay on the lookout for profitable opportunities, but remember that preserving capital is always number one. Making money is number two.

Best Returns,

 

Scott O’Neil

President, MarketSmith Incorporated

Follow Scott O'Neil at Twitter.com/WScottOneil