Wild Ride

This story appears in the February 1997 issue of Entrepreneur. Subscribe »

What a difference a year makes. In 1996, despite some pitfalls, the Dow managed to break through and close above 6,500, continuing its seemingly endless upward march.

Even if you're not a member of the Sierra Club, the names of certain animals may linger on your lips: With the market so bullish now, can bears be far behind? Whether you classify yourself as bullish or bearish, one thing holds true: Knowing when to buy or sell is as important as knowing what to buy or sell.

For stock investors, the past two years have seemed like a fairy tale; even the ugliest duckling turned into a swan. As stock markets climbed to new highs, creating vast sums of wealth, investors barely noticed the passage to the next round number. Pundits urged them on with projections of the Dow Jones industrial average at 7,000 by 1997 or 10,000 before the end of the century. Others urged caution, citing the Newtonian theory of the stock market: What goes up sooner or later comes back down . . . even if only briefly. The question remains, which animal will end up on the endangered list--bulls or bears?

Predictions of stock performance and investment timing are based on a myriad of indicators, from the style of women's fashions (shorter hemlines and higher heels are considered bullish) to the level of consumer debt (high debt is considered bearish). Making sense of the movement of stocks is tough enough, but to predict the market's next move, you may want to rely on your fairy godmother.

There are two general approaches to timing the purchase or sale of securities:

*Fundamental analysis uses information on economic growth and industry and company statistics to estimate the value of an individual security and the valuation of the market. Information is often gleaned from annual reports and studies of a company's earnings, dividend yield and its price compared to its earnings.

*Technical analysis relies on the assumption that stocks trade in definite and predictable patterns. The most popular type of technical analysis involves charting a stock price's movement and looking for trends that will enable you to predict future market movements.

If you're used to talking about bull and bear markets, you're already familiar with the charting aspect of technical analysis. The use of the terms bull and bear to signify different movements of the equity markets probably started with the advent of the Dow theory, one style of technical analysis named after Charles H. Dow, an editor of The Wall Street Journal during the early 1900s. Although originally designed to predict changes in business activity, the Dow theory has become popular as a way to forecast stock market activity.

Prince Or Pauper?

At its most basic level, a bull market is one in which most stock prices rise, while a bear market is when stock prices fall. Bull markets develop in four phases.

In Phase One, stock prices are low, and investors are exasperated with stocks because of their recent decline. Few investors are interested in stocks, and many are convinced stock prices may never rise again.

During Phase Two, stock prices start to rise and trading activity increases. Corporate earnings increase, and the economy looks healthy. People decide maybe stocks aren't such a bad investment after all, and they slowly return to stocks.

In Phase Three, both business and financial markets look great--in fact, everything's coming up bullish. The markets are reaching new highs, and everyone is talking about their portfolios. Your broker is your favorite person. You almost talk to him or her more often than you speak to your spouse. By this time, most stocks are at new highs and may be at the top of what they're worth. The dividend yield of the averages is low compared to historical levels because of overvalued stock prices, and Phase Four is right around the corner.

The final phase of a bull market is marked by speculation and frenzied buying of stocks that have no apparent value or earnings. Initial public offerings (IPOs) are the hot item of the day, the name of the latest company to go public is on everyone's lips, and stock prices have gone into orbit.

Often, bear markets are marked not by a single cataclysmic event (like a market crash), but by a gradual eroding in the fabric of the market. Like its fellow animal, the bear market is composed of four phases.

Phase One starts during the last two phases of the bull market, where investors who purchased low begin to sell their stock and take profits. Market rallies become less pronounced, and there is less potential for profit.

Some technicians call Phase Two of a bear market "the panic stage" because stock prices decline sharply. Investors sell shares to avoid even bigger losses as stock prices come back to earth. Unfortunately, the faster people sell, the faster and further stock prices fall, so they sell more--and on and on.

Phase Three sees some improvement in stock prices, as prices rise and investors recover from very oversold conditions. Phase Four often involves a long slide in stock prices as values drift ever lower until investors decide they are low enough and the buying (and the bull market) resumes.

The Sky Is Falling!

Since the current bull market began in 1990, stocks have performed so well that many investors have become accustomed to double-digit returns. Hours are spent in pursuit of "the best" stocks; asset-allocation theories are thrown to the wind in search of the next stock that will quadruple and split four times in as many months.

Many people seem to have forgotten that while investing in securities offers some exceptional opportunities to profit, the securities markets are equally filled with risks. Pretend for a moment that you can measure years of "bull life" in people years, sort of like you do with your dog. If one year of human life equates to seven years of bull life, then the bull is about 42 years old--and he's been running a marathon for most of that time. Sounds like he's due for a rest.

Consider also how the final stages of a bull market are characterized (speculative purchases, lots of IPOs coming out to sharply increasing prices), then take a look around you.

Humpty Dumpty Sat On A Wall

When the market sold off sharply in July of last year and rallied back in the fall, investors got a painful lesson in volatility. Although the media emphasized price-earnings multiples and dividend yields as reflections of fundamental valuations, it's also prudent to note certain additional indicators that reveal the market's volatility (and, some say, future performance).

A stock's beta measures its volatility compared to that of a broad index, like the Standard & Poor 500. A stock whose beta equals 1 rises and falls in step with the market. If a stock's beta is 1.88, that means that if the market rises 10 percent, the stock should rise 18.8 percent. Or, to put it another way, the stock movement should be 88 percent greater than that of the market. High betas are positive in rising markets but worrisome in falling markets.

Before you decide that a stock's beta is the key to a successful investment program, it should be noted that betas don't always work for individual stocks. Betas reflect a stock's relationship to the market but don't determine its direction. Investors who think the market is going to go up should have portfolios with betas greater than 1; if they think the market is going to go down, the beta of their portfolio should be less than 1.

No matter what kind of tools you use to decide how to invest, if you buy stock, be sure you've covered your assets. High levels of consumer debt, lower-than-anticipated corporate earnings and many stocks trading at record highs make for sleepless nights.

Nonetheless, if you feel the shares you own have still more potential upside and you don't want to take your profits just yet, consider buying protective put options on these positions (see "Personal Finance," September 1996). The purchase of a put option allows its owner to put (or sell) shares of the underlying stock at a specific price, regardless of how low the stock goes. In this case, a put option acts like insurance. Should the stock continue to rise in price, the put would expire worthless. One caveat, however: Talk to your accountant before purchasing options, as certain tax issues must be considered.

Along Came A Spider

Not sure how the market will trade? Unlike Miss Muffet, don't let SPDRs and LEAPS frighten you away. Using these investment tools allows investors to participate in the market on the upside or protect their portfolios on the downside. Standard & Poor's Depository Receipts, also known as SPDRs, represent ownership in the SPDR trust, an investment that was established to accumulate and hold a portfolio of common stocks intended to track the price performance of the S&P 500 composite index. Holders of SPDRs are entitled to receive proportional quarterly distributions corresponding to the dividends that accrue in the S&P 500 stocks in the underlying portfolio, less trust fees.

SPDRs trade like any listed stock. Each SPDR represents about one-tenth the value of the S&P 500. If, for example, the S&P were trading at 700, the SPDRs would trade at about $70 per share. The purchase of one round lot (100 shares) would cost about $7,000, plus commission.

To protect your investment in SPDRs, you can purchase LEAPS on the S&P 500. Long-term Equity Anticipation Securities (LEAPS) are the long-term options (puts and calls) on stocks that provide an investor with the right to purchase or sell shares of a security at a specified price on or before a given date up to three years.

To balance a round lot of SPDRs, you could buy one LEAPS put for about $500. These puts act as insurance for the SPDRs and for portfolios that approximate the S&P 500. By purchasing protective puts, an investor can quickly take advantage of the market's potential upside and remove much of the downside risk. So even if you feel like you're stuck in a corner, at least you'll have the chance to pull a plum from your pie.

Lorayne Fiorillo is first vice president of investments at Prudential Securities. She presents retirement planning and personal finance workshops worldwide. For more information, write to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.