Nervous About Optimism

This gives me pause, since buoyant optimism about stock prices often signals a market peak. If early rallies climb a wall of worry, as traders like to say, they often end in a euphoric burst. Don't get me wrong: I'm as delighted as anyone by the surprising strength in the market and my accompanying good fortune. Although I recommended some modest profit-taking on the euphoria of the Dow Jones Industrial Average breaking through 12,000, we're not yet at one of my selling points, which won't arrive until the Nasdaq reaches 2500 (2515 to be precise, but round numbers are easier to remember). That seemed far away when I recommended buying stocks in June, with the Nasdaq well below my last buying threshold of 2138. Now it's fewer than 150 points away, and it seems possible we could get there in a matter of weeks.

If so, 2006 is shaping up as a remarkable year. It's already offered a major selling opportunity (April), buying opportunities (June and July) and may now be headed for another selling threshold. After the low volatility of recent years, this has made for a busy (and profitable) year at Common Sense. I alerted readers to buy stocks on June 13 and 20, and since then the Nasdaq has gained an impressive 14%. Still, this wasn't perfect timing. Over a volatile few weeks the Nasdaq continued to fall, and I reiterated my buy recommendation on July 18. That was pretty close to the low for the year of 2012.78, which arrived three days later. Since then the Nasdaq has gained 17%.

Until recently, I don't think anyone would have predicted this. Nearly all the news seemed bad, whether geopolitical (Iraq, Iran and North Korea) or economic (soaring oil prices, a housing slump, rising interest rates). Then the Federal Reserve stopped raising short-term rates, oil prices plunged, and consumer confidence soared. Given the despair of midsummer, it was a potent recipe for a rally. Since then, companies have obliged with generally strong earnings. To me this again vindicates the Common Sense formula, which never tries to predict where stock prices are headed. It only looks at where they've been, buying or taking profits accordingly (the approach is spelled out in detail in those earlier buy and sell columns, including that of April 4).

What to buy or sell at those junctures is a different issue, and lately I've become enamored with using price-to-earnings-growth ratios as well as recent price movement as a way to identify over- and undervalued stocks. In September, I identified low PEG stocks to buy, including some large mining and basic materials companies, and stocks in the technology, retail, and home-building sectors. It's still too soon to know how these stocks will fare in this rally, since we haven't yet reached a selling point. But thus far, the results are promising. Although oil companies have dropped and mining companies have been stagnant, the other sectors have rallied strongly. Microsoft (MSFT) and Intel (INTC), two big technology companies I recommended in June, have done especially well, with Microsoft recently over $28 after falling to $21.50, and Intel at $21.45 after dropping below $17. The Microsoft call options I recommended on May 9 are up even more — 40%. This demonstrates that even a conservative options strategy, when it works, can generate big gains. The Nasdaq 100 Exchange Traded Fund (QQQQ) has also done well. At $38 on June 20, it closed this week at $42.43. Other stocks I mentioned, including Nordstrom (JWN), Pulte Homes (PHM) and Toll Brothers (TOL) have rallied sharply.

Naturally, a big rally tends to make any stock picker look good, since so many stocks go up. But for a midterm report card, I'll take these results any time. Meanwhile, I'm enjoying the rally — and dusting off my list of stocks to sell.