Recently, I have been studying the earnings and dividend performance of different blue-chip stocks during some of the worst economic periods in our country's history (1929-1933, 1973-1974, 2008-2009) with a particular focus on The Great Depression. One of the things that I have learned is this: the pain of loss during many major stock market corrections is amplified by the fact that many of the stocks were overvalued in the period that preceded the severe decline.
For instance, a superficial look at the hemorrhage during the Great Depression years reveal that the stock market completely fell apart (valuation wise). And largely, it did. The Dow Jones Index (NYSEARCA:DIA) fell 17% in 1929, 34% in 1930, 53% in 1931, and 23% in 1932. Those are steep declines, to be sure. No one is arguing that point.
But here's the context I'd like to point out. In 1928, the Dow Jones Index rose 48%. This drove the valuations of the index components to just shy of 30x earnings. AT&T (NYSE:T), IBM (NYSE:IBM), and the predecessor to Bank of America (NYSE:BAC) were either trading at their highest or second-highest valuations ever in their respective histories as publicly traded companies.
According to John Bogle, the legendary founder of Vanguard, those companies should have been trading at 15x earnings during that period, in line with historical P/E ratios of American large-cap stocks during periods of fair valuation. For my investment decisions, that is something important to keep in mind. The destruction of wealth, in terms of net worth, is not merely caused by stocks going from a period of "fair valuation" to "undervaluation." Rather, it is the transition from moderately high "overvaluation" to "undervaluation" that can cause much misery to investors, from a net worth perspective. Going into the Depression era stock market, many stocks were trading at twice the price they were worth. This accounts for a portion of the pain that the stock market investors experienced during the Great Depression.
If you are concerned about steep declines in your net worth from peak to trough, then it may make sense to trim some stocks that are approaching significant overvaluation in your portfolio, even if they happen to be excellent companies. Hershey (NYSE:HSY) chocolate would be one of my favorite stocks to hold for the long term, but with its price approaching 30x earnings, I couldn't justify the price entry (especially considering that its historical P/E ratio is 19x earnings). Same thing with Brown-Forman (NYSE:BF.B), the legendary alcohol producer that owns brands such as Jack Daniel's and Southern Comfort. The company removed a significant portion of cash by paying out a $4.00 special dividend last year (thus impairing the balance sheet for new shareholders) and is currently trading at 25x earnings, above its historical average of 19-20x earnings.
Think about the implications of holding Hershey or Brown-Forman should we experience a stock market correction that makes these companies undervalued. In Hershey's case, the first 30% or so of the decline (depending on how you calculate Hershey's normalized earnings) would merely be a reversion towards fair value. In Brown-Forman's case, the first 25% cut in price would merely be a return to fair valuation. It would only be from there that the decline in net worth would be the result of the company becoming undervalued. An intelligent way to prepare for a stock market correction is to remove the moderately overvalued (or more) stocks from your portfolio because they stand to experience a double whammy: (1) a sharp decline that accompanies a reversion to fair valuation, and (2) the decline to undervaluation that occurs during periods of bear market stock pricing.
Of course, if you are capable of ignoring high fluctuations in net worth and only want to own excellent businesses for long periods of time that grow earnings and dividends just about every year, then holding on to companies like Hershey and Brown-Forman might make sense. Since June of 1990, a $10,000 investment in Hershey would have turned into $159,000 (even though Hershey's valuation was as high in 1998 and 1999 as it is now). That's excellent wealth creation. Likewise, for Brown-Forman, a $10,000 investment in June 1990 would have turned into $138,000 today (even though the company was significantly overvalued in 1998 by trading at 24x earnings).
Holding excellent companies through periods of overvaluation does not doom the wealth creation process. Rather, it just means that investors will have to spend a few years dealing with P/E compression (which can be alleviated somewhat when accompanied by earnings growth) and investors may have to experience particularly steep declines in net worth if there is a rapid transition from the period of overvaluation to the bear market.
Ultimately, you need to determine your goals as an investor, and find a way of executing that strategy that is consistent with your identity. If guarding against those dreaded 50% paper losses is something that you want to be active in monitoring, then selling overvalued stocks may make sense, because history shows that losses are amplified if we transition from periods of strong overvaluation to undervaluation in a short period of time. If you are content to focus on the business performance alone, and have the fortitude to sit back and count your dividend checks even if your stock falls 40-50%, then the best preparation for a depression would be to make sure the businesses you own are excellent enough to withstand a downturn in the economy. It comes down to how well you know yourself to determine which of the two paths is most consistent with achieving your investment goals.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.