Bear Repellent For Your Stock Portfolio

 |  Includes: CVX, MCD, PG, SPY
by: Eric Parnell, CFA


Many investors that are skeptical of today's bull market face a dilemma - buy now and absorb losses or sell now and miss further gains.

By applying "bear repellent" to their stock portfolio, investors can maintain stock allocations while also protecting against the risk of bear market declines.

Three additional steps among others in the stock screening process may be worth consideration in applying bear repellent to a portfolio.

Suppose you are concerned about the sustainability of the stock market rally. You believe the fundamentals underlying the economy and the markets are built on sand, and you may have even felt this way for a long time. But you also see a stock market that seems to only rise day after day after day. This results in a dilemma. You do not want to buy into the market in which you are already deeply skeptical the moment it finally peaks and enters a new bear market. The mere thought of it may even be distasteful. Yet you also may not want to absorb the opportunity cost of standing aside if stocks are insistent on adding a few more months or even years to the current bull market. What is the conflicted stock investor to do? The answer? Apply bear repellent where possible to your stock portfolio.

It is a sense of internal conflict that many investors find themselves grappling with today. You look around and see a domestic and global economy that despite all of the flashy headlines is continuing to struggle to regain momentum toward a sustainably strong recovery. When you take a step further and explore the fundamentals, you find that many companies are struggling to increase revenues and seem to be relying a bit too much for your liking on cost cutting and debt funded share repurchases to boost earnings per share. And then when you check the valuation on many of the stocks you might like to own, you cringe at the price tag you have to pay. But despite all of these legitimate concerns, the problem is that these have been issues for the market for the last several years, yet the stock market continues to march higher in setting new record highs.

You may believe this all will end badly. But when does it all end? On Monday? In October? Or 2017?

Given this uncertainty along with the fact that the market remains in a sustainable uptrend and the recognition that as evidenced by the news out of the European Central Bank that the world is still not at a loss for major central bankers that are willing to do (or at least suggest that they will do) whatever it takes to try and wring the last drops of blood out of the global recovery stone, it remains worthwhile at least for now to maintain a meaningful allocation to stocks.

But this raises another predicament for the skeptical investor. During a raging bull phase, the market is filled with investors that all think that they can ride the rally to the top and get out before the next bear market fully takes hold. Unfortunately for the many holding this belief, one of the cruelest characteristics of a bear market is that most investors are not even aware that they are in the throes of major downturn until it's way too late. By the time they realize the market has officially turned, they look around and suddenly find themselves down -20% to -30% or more with no way out. In short, they are essentially trapped and are forced to ride out the downturn for as low as long it is determined to go.

Of course, many investors have an excellent retort to this predicament. Go out and buy with conviction the stocks of high quality companies, particularly those that have steadily growing dividends, and hold on to them through the downturn no matter how severe the losses may become along the way. As long as the dividend keeps growing, the decline in value is nothing more than a paper loss that will eventually be recovered once the next bull market begins. This is an outstanding approach and I agree completely with this strategy. In fact, such is the strategy that resides at the core of my investment philosophy.

Unfortunately, two key challenges present themselves with this approach.

First, while it is easy for many investors to say that this is what they intend to do when the next bear market finally arrives, it is far more difficult to actually carry this out in practice when the principal value of your investments are falling by -30%, -40%, -50% or more. For while being out of the market when it is rising is painful enough, it is far more gut wrenching to be in the market when it is falling relentlessly day after day. Eventually, it can break the most resolute of portfolio managers. And it has been a long time now at over five years since investors have felt such prolonged pain.

Second, the possibility actually exists that stocks may correct during the next bear market and not bounce back to their previous price levels for a very long time. Investors over the last 30 to 65 years have been conditioned to the idea that stocks will bounce back fairly quickly after plunging into a bear market the same way that homebuyers were conditioned for 60 years to the idea that home prices never sustainably declined up until the financial crisis took place several years ago. But the primary drivers of these sharp reversals in stock prices after bear markets have been the strength of the economic recovery that accompanies it along with highly accommodative monetary policy from the U.S. Federal Reserve. But when looking ahead to the next bear market, what is the likelihood that either of these conditions will present themselves next time with the economy already having struggled to regain strength for so many years and a Fed balance sheet having already more than quintupled to $4.3 trillion trying in vain to ignite more robust growth? In short, the double barreled shot gun that has sparked past rallies following bear markets may be left firing blanks the next time around, potentially leading to a far longer road back for many stocks to current price levels than most anyone is expecting.

The Value Of Bear Repellent For Your Stock Portfolio

Fortunately, reasonable answers exist for such skeptical investors that wish to participate in further stock market (NYSEARCA:SPY) gains while still protecting themselves from getting caught in the next bear market despite all of these challenges and concerns. The following are three fairly straightforward additions to a stock screening strategy that may help to provide a layer of bear repellent protection on your stock portfolio.

1. Focus On Yield And Dividend Growth

This, of course, is a concept with which many readers are very familiar. As mentioned above, one of the best ways to perform in any market is to emphasize companies in your portfolio that are able to support an attractive dividend payout and are also able to sustainably increase this dividend payment over time. This way, no matter what the price of the stocks you are holding may be at any given point in time, as long as the dividend payout is growing, you are achieving a consistent increase in portfolio income over time.

This approach has particular appeal if you are concerned about the potential for a change in market direction at some point in the future. For if stocks were in a better case scenario to enter into a sideways consolidation phase, you would still be benefiting from a steady stream of increasing portfolio income as the market worked its way through this process assuming you selected the right names in advance. And in a worst-case scenario the stock market were to plunge into a more dramatic decline, you will still have the income being generated by your portfolio to help offset the decline in principal value sustained along the way.

2. Focus On Stocks Whose Prices Have "Life"

What the heck does "life" mean in relation to a stock price, you might ask? This second point is a bear repellent in recognition of the fact that five years of aggressive monetary policy stimulus from the U.S. Federal Reserve has had a highly distorting impact on financial markets including stocks. One of the defining characteristics of this distortion has been the increasing trend across many security prices, particularly since the beginning of 2013, to enter into zombie like phases where they start drifting higher for months with virtually no price volatility along the way.

The following is just one of many examples of stocks and entire asset classes for that matter that have entered into extended periods of zombie like behavior. In order to protect the identity of the company shown here, I have removed any references to its name or pricing. All I will say is that it is a top 100 market cap company that is among my favorite high quality stocks that I have owned on several occasions in the past but do not own today.

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So what exactly is the problem with stocks entering into these sustained periods of gains with minimal price volatility? Because this is not what would be considered as anything close to normal price behavior, as it suggests that other potentially unhealthy and unsustainable forces have suddenly caused the stock price to turn comatose. And while such zombie like behavior is certainly nice when it is moving in your direction - I have been the direct beneficiary of such zombie like moves along the way - they often end badly once the security price snaps back to life. For while this was not the case with the security shown above, it was the case for many others during the sudden market awakening last May and June such as the one shown below that has taken a full year to finally recover the value lost in what is still a raging bull market for stocks.

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In order to protect against the potential for a sudden sharp decline in value, it may be best to focus on securities that are consistently showing "life" in their price. This includes more normal up and down price movements on any given day and a reasonable amount of price volatility along the way. Taking this one step further, it may be even more ideal to focus on high quality dividend growing stocks that are consistently showing continuous "life" in their stock price and are either being disregarded or discarded by the market at the present time. The following are three such examples among many in Procter & Gamble (NYSE:PG), McDonald's (NYSE:MCD) and Chevron (NYSE:CVX). It should be noted that each are Dividend Aristocrats with annual dividend yields in excess of 3.2%, which qualifies each to pass the first screen mentioned above.

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3. Focus On Stocks That Have Proven "Emergency Exits" From Bear Markets

The ideal situation is to purchase a stock that you can hold forever. In the interest of full disclosure, while I have purchased a number of stocks over the last year, I have not sold any holdings since last August. And as long as the current stock market uptrend remains intact, I am likely to continue to maintain these positions. In fact, I am likely to continue to hold many of these positions even after the next bear market initially gets underway. Why? Because each stock position in my portfolio with the exception of one was purchased after being screened for having a proven emergency exit hatch from a major bear market (the one exception being a name owned for direct high beta exposure).

This is arguably the most important characteristic of the three listed here. But what exactly do I mean by an "emergency exit"? These are stocks that have demonstrated the ability at best to continue rising or at worst hold even well into the onset of past major bear markets.

Returning to the examples highlighted above demonstrates what an emergency exit looks like, which are shown in the charts below during the last major bear market from 2007 to 2009.

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The last major bear market got underway in July 2007. And although the stock market subsequently faded into a sustained -20% decline over the next 14 months through September 2008, both Procter & Gamble and McDonald's were trading between +15% to +25% higher over this same time period. As for Chevron, it was higher through July 2008 and was down in the low single digits in the few weeks after the Lehman bankruptcy in late September 2008. In each case, investors had more than enough time to consider whether a sustained bear market was underway and to decide whether it would be more prudent to stay the course or to evacuate these positions either with gains in the case of P&G and McDonald's or only a modest decline in the case of Chevron. It is worth noting that all three stocks demonstrated this same resilience during the 2000 to 2003 bear market, as both Chevron and McDonald's held up in positive territory until mid 2002 while Procter & Gamble never relented to the downside.

While there is no guarantee that a stock including any of those shown here that held up well during recent past bull markets will do so again during the next bear market, it is at least worthwhile to have the demonstrated ability of having successfully done so in the past.

Bottom Line

The use of bear repellent in the wild does not guarantee that one will not suffer injuries from a bear attack. But the application of the spray does help to minimize the potential for damage from such an unfortunate encounter. And the same principles hold true when managing your investment portfolio. For applying some theoretical bear repellent through methods such as those shown here among others, one can position themselves to participate in any potential further market upside while still managing against the risk of major stock portfolio loss.

Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am long CVX, MCD, PG. 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.