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What to Do When Stocks Hit the Bargain Rack

by | published May 14th, 2014

Over the past week, oil and gas stocks have been quite volatile. But that’s not bad news – not by a long shot.

In fact, this is always the time when energy investors should be on the hunt for bargains.

And don’t worry. None of this volatility indicates the markets are on the cusp of a significant dive, even though the doomsday forecasters are out in full force.

Of course, these guys always sing the same tune, preaching Armageddon on a regular basis. After all, if nothing else, the law of averages will allow them to be right at least once!

But that’s not happening anytime soon. There are simply no major problems on the horizon at the moment, even though some select energy shares have dipped.

That leaves us with what to do after the recent hiccup in oil and gas stocks.

In this case, the best approach is rather straight forward…

Get Busy When Your Stocks Go on Sale

It’s called dollar cost averaging and it’s a smart way to lower your cost basis when your shares “go on sale.”

Now keep in mind this is not something you want to do with all of your holdings. Some stocks will take much longer to recover and should be sold. In fact, as a rule of thumb, I recommend you use trailing stops and stick to them.

A trailing stop is one that follows the high price of your shares from inception. As the share price climbs, the stop loss – set as a percentage – climbs right along with it. This allows investors to lock in their profits and insulates them against any deep losses. It works because it takes the emotion out of the trade.

However, when the losses occur within an acceptable range, it’s smart to dollar cost average. Simply select the positions among your holdings that have good fundamentals and have undergone appreciable declines beyond those justified by quarterly reports and buy them.

Even with disappointing earnings reports, companies that have strong prospects for production (upstream oil and gas operators), transport and storage volume (midstream, especially master limited and other partnerships carrying higher than average dividends), and processing /distribution (downstream refineries and wholesale sale networks able to balance domestic and imported sources of raw materials and finished products) make for secure targets.

The reason is simple. Markets tend to overreact to disappointing earnings, punishing the stocks. That means normally solid companies will bounce back quickly.

One wrinkle to consider in all of this is the so-called “wash sale rule.”

If you sell shares at a loss and then decide to buy them back within 30 days, you cannot take the loss on your taxes. A sale at a reduced profit obviously does not apply here, only those where the price realized at liquidation is lower than the price at which the shares were purchased.

But let’s say that you do end up selling at a loss. Does that mean dollar cost averaging before the 30 day wash sale period is up will always result in a disadvantage?

No.

The rule is there to prevent investors from attempting to churn through a down market move with repetitive buys and sells. Depending on the situation, it may still be to your advantage to buy back in even if that means foregoing a tax loss.

If the stock is likely to bounce back in the short-term, well within the 30 day period, the resulting price at the end of the period may still be a bigger cost than the tax loss afforded by the rule. In other words, there are companies that tend to perform strong enough to make dollar cost averaging a good move even without a tax benefit.

Remember, the objective of dollar cost averaging is to lower your actual cost per share. So each resulting advance in the share price will hand you a greater return than you would have gained by sitting on the sidelines.

It isn’t free money, but the next best thing.

What to Watch Out For

The biggest decision involves when to make your move. Just know that companies with good fundamentals will respond faster than the sector as a whole. That means, on average, a quality company that declines by double-digits in a week will usually rebound over a similar time frame.

The exception would be during what technicians call a high kurtosis event. This can get pretty complicated, so I’ll just give you the bottom line. Kurtosis is something statisticians use to identify a very large deviation from the norm over a short period of time.

We have experienced this scenario a few times in the last several years and each occasion has resulted in disproportionately negative results for energy stocks. Deviations like these happen all the time because markets are never static.

But when more of the downward moves are concentrated in short intervals, it’s a sign that a kurtosis is taking place. These are not usual and they are not merely corrections. It feels like the floor has dropped away.

However, there are almost always signs such a shift is about to take place. And we have none of them currently. Unfortunately, the wild card here is always geopolitical events.

Nonetheless, for the moment, dollar cost averaging is a safe bet with normally solid stocks.

P.S. Talk about bargains… I’ve found an entire market segment that is so oversold it borders on the ridiculous. The last time it was this beaten down, a handful of stocks jumped over 1000%. This opportunity has only happened twice in the last 100 years. You don’t want to miss this…

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