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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:
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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. |