3 Steps to Big Profits in This Crazy Market

Take a look at the market's 10-year roller-coaster ride:

Source: Capital IQ, a division of Standard & Poor's.

If you're an investor, do you know what you've earned -- besides a bellyache -- for enduring those violent ups and down? In real terms, virtually nothing. Less than 1% annually.

Two 40%-plus declines have decimated both the index and the many portfolios that reflect it. It's unlikely we've seen the last of that volatility. A Morgan Stanley study shows that markets generally go through another five to seven years of swings following a bear market. So we're presented with a stark choice. In the words of multibillionaire hedge fund manager Paul Tudor Jones, we can either "adapt, evolve, compete, or die."

I don't know about you, but to me, adapting, evolving, and competing sound like better options. How? With these three resolutions:

  1. Find the best investments in the strongest macro trends.
  2. Trade if trading is the right thing to do.
  3. Only bet with the odds.

Let's take a brief look at each. Then, if you're intestested, I'll offer you three strong trends and one moneymaking trade to make the most of these strategies.

Look at the big picture
I'm not the only one having an epiphany here. Legendary hedge fund manager David Einhorn came to the same conclusion in 2009:

The lesson that I have learned is that it isn't reasonable to be agnostic about the big picture. For years I had believed that I didn't need to take a view on the market or the economy because I considered myself to be a "bottom up" investor.

Putting that revelation into action, Einhorn has made gold his largest portfolio position. He owns not only physical gold, but also shares of Market Vectors Gold Miners ETF, which holds companies such as Barrick Gold, Goldcorp (NYSE: GG  ) , and Newmont Mining (NYSE: NEM  ) , to name its biggest positions. Why hold gold and gold miners? Einhorn uses these investments as insurance, believing that our "monetary policies and fiscal policies don't make sense."

Take it from Einhorn: The economic environment matters, and bottoms-up stock picking isn't enough anymore. Investors ignore that reality at their portfolios' peril.

It's not enough to know that Annaly Capital (NYSE: NLY  ) and Hasbro (Nasdaq: HAS  ) have fantastic management teams and nice dividend yields. (OK, Annaly's yield is a bit nicer.) We need to understand how interest rates affect Annaly's investment outcomes, and how consumer spending trends will sway Hasbro. The environment matters, and we have to adjust our investing decisions accordingly.

The right tools for the job
Crestmont Research founder Ed Easterling has spent his career studying the stock market. In the pages of his fantastic books, Unexpected Returns and Probable Outcomes, one message stands apart from the rest: Investors must have a flexible investment strategy that can shift with the market's currents.

The chart below illustrates the point perfectly:

Source: Crestmont Research.

Massive market swings -- not unlike the volatility I expect to see in the future -- chewed up and spit out buy-and-hold-only investors. Being willing to trade more frequently could have reduced their headaches -- and their losses.

Neither Ed nor I preach market timing. But consider this: A good carpenter has a truck full of tools, and the knowledge to pick the right one for the job. Investors would be wise to remember that in volatile markets, not every investment lends itself to buy-and-hold forever. Trading doesn't have to be a dirty word, as long as it's based on changes in overall conditions.

Viva Las Vegas!
A quote from Warren Buffett's legendary business partner, Charlie Munger, explains what it means to "bet with the odds":

The model I like to sort of simplify the notion of what goes on in a market for common stocks is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market.

It's difficult to value companies with precision. But we can make estimates, then compare those values to market prices to get a sense for the odds. Betting when the odds are clearly in our favor should produce more gains than losses over time.

Of course, there will be losses. Even the best investors aren't perfect. Buffett himself lost money when he bet on Irish banks -- most likely Bank of Ireland (NYSE: IRE  ) and Allied Irish Banks (NYSE: AIB  ) , two companies that bore the brunt of the collapse of the Irish economy and now struggle to survive. And I was right there with him on Allied, making the same mistake, even if my loss was smaller.

Yes, that loss hurt. But estimating and betting with the odds is still the best strategy, because our winners more than make up for our losers. For example, I bet heavily with the odds on independent power generation company AES following the bursting of the energy bubble in 2002. That 10-bagger produced outstanding returns for my portfolio. Over the long haul, success in the stock market comes from betting heavily when the odds are in our favor, passing when they are not, and keeping our losses manageable.

The perfect plan
Financial markets and the U.S. economy have recovered from their 2009 lows, but we're not out of the woods yet. Odds are good that we'll see plenty of volatility in the future. To be ready, I've come up with this new investing strategy because:

  1. Powerful things happen when trends converge, diverge, emerge, or combine together.
  2. Sometimes it's better to trade, and other times it's better to hold.
  3. I would rather be vaguely right with the odds than precisely wrong with intrinsic value.

I'm going to invest $50,000 of my own money with this approach, which I expect to pay off over the next several volatile years.

If you'd like to find out about the three strong trends and the money-making trade that I see, I'll be happy to send you a brand-new report I've written on the subject for free. Simply click here and enter your email address in the box to let me know where you'd like me to send it.

David Meier is an associate advisor for Million Dollar Portfolio. He doesn't own shares of any company mentioned. Hasbro is Motley Fool Stock Advisor picks. Hasbro is a Motley Fool Income Investor choice. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (44)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 23, 2011, at 8:22 AM, xetn wrote:
  • Report this Comment On April 24, 2011, at 2:38 AM, hbofbyu wrote:

    Interesting. That 10 year gold chart looks exactly like Cisco's chart did in the year 2000. Cisco was a sure thing and it had the prettiest chart you have ever seen. I lost more money in Cisco than all my other loses added together. Every drought ends in rain and every rise ends with a fall - eventually.

  • Report this Comment On April 30, 2011, at 11:45 AM, mike2153 wrote:

    This seems to be the Anti-Fool philosophy.

  • Report this Comment On May 03, 2011, at 2:15 PM, mikecart1 wrote:

    3 Steps:

    1. Log on to Motley Fool

    2. In the search type "mikecart1"

    3. Examine CAPS portfolio and enjoy life.

    :D

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