Published: August 29, 2009

The market has had a nice run-up in the last few months. In fact, this rally may be a little too good to be true. Many people are starting to worry that the market has gotten ahead of itself and there is some evidence to support their fears.

The P/E ratio of the S&P 500 Index is about 19 -- a five-year high. That's a pricey valuation for stocks, considering we're barely seeing "green shoots," let alone a full recovery.

And of course, this is the time of year to worry. Many of the market's biggest pullbacks have come in October -- just weeks away.

But I'm not nervous. If it comes, I'm ready for it. I saw what happened last year and I know exactly what I'm looking for: Closed-end funds trading at historically 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, closed-end 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 portfolios.

When panic reigns, closed-end funds can get so oversold they start to trade at huge discounts to their NAVs -- when you can literally pick them up for 60 cents on the dollar.

But you have to move quickly. These massive discounts 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, let's look at four examples from last year:

In three out of our four examples, the value of the fund's underlying assets actually dropped. But because the discount narrowed, every one of these investments gained over +25% in less than a month's time.

This is just a sample. Dozens of closed-end funds experienced the same phenomenon.

No one really wants a market correction. I think we'd all like to see a full blown economic recovery and a continuation of this year's rally. But if a correction is coming, closed-end funds represent a rare pullback opportunity.

Here are some tips on how to play closed-end funds in a downturn:

Plan ahead. You may only get a few days to capitalize on widening discounts. Know ahead of time what you want to buy.

Buy a fund for its merits. Only choose a closed-end fund that meets your individual investment needs. Don't just buy a fund for the discount. In the event that discounts are slow to narrow, you will still have the satisfaction -- and eventual benefit -- of picking up a solid portfolio at a large discount.

Know a fund's premium/discount history. Before you can decide if a fund is trading at an abnormally large discount, you have to know what its "normal" is. Some closed-end funds normally trade at a -10% discount, while others normally trade at a premium. Every fund is different. There are a number of good online resources for premium/discount information, including ETFConnect.

Always Searching for the Next Great Idea...

- Amy Calistri
Chief Investment Strategist
StreetAuthority Stock of the Month

P.S. -- I've already picked my favorite closed-end fund and profile it in the September issue of my Stock of the Month newsletter. To find out more, click here.