If the Market Craters, Here's My Plan

Amy Calistri's picture

Wednesday, May 26, 2010 - 12:57pm

by Amy Calistri

To say the market has been "moody" as of late would be an understatement.

From its low in March 2009, the S&P 500 gained +80% before reaching its peak more than a year later. And now, in about a month, it's dropped -13% -- that includes the May 6th debacle that saw the Dow drop -10% at one point in the day.

All of this has made the Volatility Index (VIX) -- a measure of volatility and thus, fear, in the markets -- triple since April. Confidence is in short supply.

We'd all love to see a constant bull market. (Wouldn't that make retirement easier?) But as investors, you have to take the good with the bad. And the good news for us is that downturns -- especially those that are really sharp -- are a breeding ground for choice opportunities and high yields.

And if we see a sudden sell-off, I'm ready for it.

I saw what happened in previous downturns, and I know exactly what I'm looking for: Closed-end funds trading at unnaturally big discounts to their net asset values (NAVs).

Unlike open-ended mutual funds, closed-end funds don't trade at their net asset values -- the value of their underlying holdings. Instead, the funds trade throughout the day at whatever price the market decides they are worth. As a result, they can often trade at a premium or a discount to the value of their actual portfolios.

When panic reigns, closed-end funds can be so oversold they start to trade at huge discounts -- when you can literally pick them up for 60 cents on the dollar. The sharp drops also give you an opportunity to lock in some unprecedented yields.

But you have to move quickly. These massive discounts and yields don't last long before investors jump on the bargain they represent. You may get a few days. If you're lucky, you may get a week before the discounts start to close again.

To illustrate the power of these temporary discounts, look at these examples from previous sell-offs:

This is just a sample. Dozens of closed-end funds have experienced the same phenomenon -- sharp sell-offs followed by dramatic recoveries as their discounts were bought up by eagle-eyed investors.

Since these sorts of moves happen so quickly, however, you've got to prepared ahead of time. Not only do you need cash at the ready, you also need to have a shopping list in hand.

You don't want to just buy a fund for the discount. In the event that discounts are slow to narrow, you still want to have the satisfaction -- and eventual benefit -- of picking up a solid holding at a large discount.

No one really wants a market correction. I think we'd all like to see a full-blown economic recovery and a continuation of the rally. But we have to take what the market gives us. That's why you should always have a plan at the ready to profit from a sharp pullback.

P.S. -- If you're interested in learning more about The Daily Paycheck, please visit this link. I'd love for you to join me as I continue building my portfolio!

Amy Calistri does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.