Up 28% In Stocks Since July, Where to From Here?

On July 21 of this year, I went out on a limb...

On that day, the Nasdaq was at its lowest point of the year. I told my True Wealth subscribers that it was time to back up the truck and buy stocks. Most of my readers probably thought I was crazy.

Specifically I said: “I believe that, on a reward-to-risk basis, this may be our best True Wealth opportunity of 2006. I suggest you put a good amount into this trade.”

I thought the market was bottoming right then. And I told readers, “I think we could actually make a relatively safe 60% in the next six months.”

So far we’re four months into the trade, and we’re up 28%. (I recommended a simple mutual fund that leverages the returns of a regular stock index)

Why did I recommend subscribers buy stocks on July 21? My reason was simple... I told my readers this: “The common man is more gloomy about stocks right now than he was at any time during the month of the worst crash in our investment lifetimes.[October 1987]”

We simply followed one of the oldest rules on Wall Street. That rule was best defined over a century ago by the legendary investor Daniel Drew: “The way to make money in Wall Street is to calculate on what the common people are going to do, and then go and do just the opposite.”

All we did was follow that classic rule.

How do I size up what the “common man” is doing? One area I look to is the surveys of investor sentiment, like the one put out by the American Association of Individual Investors (www.aaii.com). In July of this year, the percentage of investors with a bearish stock market outlook reached an extreme that was greater than October 1987.

Truth be told, sizing up investor sentiment is difficult... Primarily, I track sentiment through my friend Jason Goepfert’s outstanding service,www.sentimentrader.com.

Jason probably tracks a hundred different sentiment indicators. He calls his headline indicator the “Smart Money/Dumb Money” confidence indicator. Backtesting this indicator to 1995, the S&P 500 was up 433%, with a 20% maximum drawdown, following his indicator. Buy and hold over the same period of time would have earned a 198% return, with a maximum drawdown of 48%.

Jason’s Smart Money/Dumb Money indicator said to buy stocks in May of last year, and it’s been bullish since. It’s been a good trade, as the major stock indexes are up about 20% since then. But times are changing now... The “dumb money” is getting optimistic... so this indicator may switch to bearish soon, after being bullish for the last year and a half.

Trading sentiment is extremely difficult. But it’s worth the effort...

Here at DailyWealth, our investing mantra is: cheap, hated, and in an uptrend. This is because I believe the very best investments come when you can find all three of these things in your favor: value, trend, and sentiment.

The thing is, there’s always someone out there smarter than you, with a faster computer... so it’s very hard to generate outsized returns by simply screening for value and trends. The one thing that’s hard to number crunch is sentiment... It’s feelings, so by definition, it’s hard to quantify. But that’s good...

To me, this means there’s still room to make outsized profits using sentiment as an indicator... Profits like the ones True Wealth subscribers have made in the trade I described above...

“The way to make money in Wall Street is to calculate on what the common people are going to do, and then go and do just the opposite.”

Keep Drew’s mantra on hand at all times. It’s how he made a fortune in the mid-1800s. It’s what we did in July 2006, which led to big profits. It’s been a profitable strategy for centuries.

On Monday, I’ll share with you one area of the markets where the common man has given up... so this investment is ripe to rally. Until then,

Good investing,

Steve

P.S. If you’d like to track sentiment yourself, check out Jason Goepfert’s website www.sentimentrader.com. It’s what I use.