What to Buy in a Pullback, Part II

Investors who are comfortable buying weakness and selling strength could be aptly rewarded

Last Thursday’s blog post turned out to be more prescient than planned. I certainly didn’t expect today’s selloff, but considering the increased hostility in the Middle East I suppose we shouldn’t have been surprised.

This isn’t yet a tradeable market retreat – I’d like to see stocks down 5%-10% - but as I said earlier, it makes sense to start planning in case traders continue dumping positions.

The purpose of buying while prices are lower is to lock in valuations caused by panicked sellers (FYI, there are also reasons to buy while prices are heading higher, but that’s a discussion for another day). But to do that, one must be willing to part with an existing position that has done well, which allows investors to lock in gains while searching for better deals elsewhere. 

One of the most interesting valuation differentials is between tech stocks and emerging market equities. The former has outpaced the latter by about 15 percentage points in the last year, with 10 percentage points of that total occurring so far in 2011 (i.e., tech is up 3% YTD, while emerging markets are down 7%). If this differential increases, it may make sense for some investors to buy the cheaper of the two, while selling the most expensive.

It is reasonable to assume that emerging markets will lead the couple lower. Investors are concerned that inflation will affect the developing world more, and some fear that a stronger dollar will attract more money to large-cap U.S. stocks, a trend that has been in place for the last four months. These are valid concerns, but the stronger fundamentals of many emerging economies are compelling. Those who are comfortable buying weakness and selling strength could be aptly rewarded.

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