Finding Value In A Sideways Market

(by Kristina Zucchi)

When the stock market moves in any one direction, either generally up (remember the late-1990s tech rally) or generally down (think the bear market of early 2000s), it is easier to make an investment decision and ride it up or down. But when the market moves sideways, or non-directionally, investment decision-making is markedly more difficult. During trendless markets, investors tend to be paralyzed with inaction. However, there are opportunities to cash in on the uncertainty and continue to profit from the market. Understanding what trends look like and the investing mentality that generally works in different market environments can assist investors in making profitable investments.

Capitalizing on an Uptrend
It is significantly easier to make money when you can invest in a definitive and recognizable market trend, but identifying what the trend looks like while it is happening is the key aspect to taking advantage of the opportunity. With a trend, you don't need to determine exact timing because it will carry you into profits. An uptrend, as depicted in Figure 1, is characterized by a steady movement up and to the right of the chart.

Figure 1

Source: Bloomberg

Between January 1996 and September 2000, the S&P 500 had a total return of 130.8% and an annualized return of 25%; there were 29 positive months and 16 negative months. The market was benefiting from an unprecedented technology boom as the personal computer began penetrating most households and the corporate world was benefiting from productivity gains and gearing up for the turn of the century. During such a tremendous bull market, investors basically needed to invest in, or be long, a technology company associated with the computing industry and let the momentum of the market propel stock gains. Similarly, during a downtrend, as depicted in Figure 2, picking the industry or sector that is the subject of the negative momentum and short selling stocks in that industry generally results in positive returns

Profiting From a Downtrend

Figure 2

Source: Bloomberg

Between September 2001 and October 2002, the total return of the S&P 500 was -26.9%, or an annualized -25.2% with eight negative months and five positive months.

After the technology boom of the late 1990s, the market came to a screeching halt, led by many factors such as oversaturation of new technology and unsubstantiated business models. During such a bear-like market, choosing a technology company that did not have a proven business and short selling the shares should have produced positive returns.