How to play an emotion driven market

Over the past year I've seen the same scenario play out about half a dozen times. I want to make sure you see what I consider to be one of the best money-making opportunities available in the current market. You've probably heard the old cliche, 'buy the rumor and sell the news." Well it's just as true (maybe more) today than ever before.

Fear is the strongest of the emotions we feel as investors. For most investors, fear is paralyzing. When stocks drop they freeze up and do nothing. This often leads to the catastrophic losses that many investors have experienced this past year. Doing nothing when the market is being driven by fear is the worst possible thing you could do. When things are tough, you can't ignore them because they are likely going to get worse, and in the case of this year, a lot worse.

What few investors realize is that stocks don't always have to go up to make money. I would say less than 5% of investors have ever made a profit on an investment that dropped in value, like almost every stock has in the past 12 months. What they don't understand is that movement is all it takes to create opportunity and it doesn't matter which direction the movement is in. Let's face it, 2008 and 2009 so far have provided lots of movement in both directions with the biggest moves to the downside.

If you look back over the past year and identify the big news stories that affected the market and the economy, you'll notice a common theme. Every market has a catalyst. In the late 90's it was the dot com boom. From 2003-2008 it was the real estate boom. Today, the catalyst for the market is the government. Like it or not, the biggest mover of the market right now is the government, and more specifically the news of any new programs they are coming up with to turn the economy around.

Think about it, the market is starving for any sort of positive news on the economy and jobs, so when the latest plan is starting to brew in Washington, investors get all excited and start buying back into the market to be in position to benefit when the plan is approved. That's the rumor part of the equation.

When the plan is finally revealed, the market tanks as everyone once again realizes that the latest plan isn't going to fix anything quickly and may not fix anything at all. Want a few examples...

How about the first bailout package, the one known as the TARP program. We were told that we needed this plan or a number of major banks were going to go under. There was enough proof in the form of WaMu and Wachovia to make us all believers. As the details of this huge plan were leaked to the press and discussed each night by the Government big shots, there was a swell of optimism that it would fix the problem. The market took off. When the bill came up for the first vote, the market raced higher in anticipation of approval. I was speaking at an investment conference in Spain that week and got on a plane to fly home the day the first vote was scheduled to take place. The news that came out at the end of the day prior was that the plan was going to pass easily. The market raced higher right up to the closing bell.

When I landed in Minneapolis after an entire day of flying, the market was now closed and when I saw a ticker tape in the airport with a steady stream of big name companies that were down for 10% or more that day, I figured something major had happened. When I finally reached a TV in the airport lounge, I saw that the vote had failed. The market immedately responded to the reality of the situation with one of it's worst day's in history, losing almost 1000 points on the Dow in a single session. Buy the rumor, sell the news. That's what it looks like my friends.

How about the election. I don't think anyone was surprised by the outcome of the Presidential election this past November, but in the weeks and days before the election the market took off in anticipation of the expected change in Washington. When the final votes were all counted nobody was surprised by the result, but the market plunged for nearly two weeks after that to it's lowest point of the year. The money was made on the upside the two weeks prior to the election and anyone foolish enough to think the pre-election rally would continue, lost it all and more the next two weeks.

We've seen the same scenario play out for the auto bailout, the inauguration and now with the massive economic bailout plan. The market rallied over the past week in anticipation of the stimulus bill only to have a huge sell off once we find out the details of the bill.

So how can you use this information to make money? Just look for the next plan to come out of Washington and determine the companies most likely to benefit from the plan. You can almost count on them rising from the first day the plan is mentioned and see them tank once again after the plan is approved or fails.

With the anticipation of each new bailout plan, the volatility skyrockets, so if you're an option trader, look to take advantage of that situation by selling spreads that are "out of the way" of the market. Put spreads as the plan is being developed and call spreads after the release. It's been as predictable as anything I've ever seen in 20 years of investing.

Buy the rumor and sell the news. Some things never change.