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Summary

  • The S&P 500 (SPY) is up 185% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% correction.
  • The best kind of correction is one that you are prepared for.
  • A market correction is an excellent opportunity to buy great stocks on sale and its extremely important that investors establish a watch list ahead of time.

The S&P 500 is up 185% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% "correction". As shown in the chart below, each of the major rallies over the past 15 years have been followed by a significant correction.

Historically, market corrections (defined as a stock market decline of 10% or more) happen approximately every 2 years on average, but the million dollar question is… will we finally see one in 2014?

Prepare For The Worst, But Hope For The Best

Like death and taxes, market corrections are one of life's guarantees. Corrections have always happened in the past and they will continue to happen in the future. That said, none of us really know when (or if) a correction will occur in 2014, but it certainly doesn't hurt to prepare for one.

Corrections can actually be a really great thing for an investor if they are properly prepared. In fact, our investment strategy is built on buying great stocks at good prices. If the market never experienced a correction, we would never get to buy our stocks "on sale". So in a way, we would welcome a nice healthy pullback with open arms.

Market Correction Survival Guide Checklist

Below is a checklist for investors to consider as they prepare their portfolio for a potential correction.

  1. Stay Calm (i.e., don't freak out and sell all of your stocks!)
  2. Selectively Raise Cash (you will need some cash to shop with)
  3. Consider Hedging Your Portfolio
  4. Build a Watch List Of Stocks You Would Like To Own
  5. Establish a "Buy Zone" For Every Stock On Your Watch List

Raising Cash

Raising cash does not mean run out and sell all of your stocks! However, you will certainly need (and want) some cash to take advantage of sale prices in your favorite stocks should a pullback occur.

A critical part of managing a long-term dividend portfolio is establishing (and adhering to) an exit strategy. A proper exit strategy should not only establish a plan to exit a losing trade, but it should also include rules about taking profits on a winner. This doesn't necessarily mean exiting a position completely either. There is nothing wrong with selling 25% or 50% of an investment that has increased significantly in price. Reallocating that capital into an opportunity with a better risk/reward profile is just prudent portfolio management.

So, how much cash should you raise?

The amount of cash you raise will vary by investor, but a good peak cash range to consider is 20%-50% of your total portfolio. Stocks can always go higher, and for that reason, you very rarely should consider moving to 100% cash. For reference, our investment plan is to always be at least 50% vested in stocks (i.e., our maximum cash level is 50% of our total portfolio).

The obvious downside of raising cash by selling stocks is potentially missing out on future gains (and income). Which is a small price to pay, in our opinion...

Consider Hedging Your Portfolio

The main purpose of hedging your dividend portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. There are many different ways to "hedge", but we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

We like to use options on the S&P 500 ETF (NYSEARCA:SPY) for our protective put strategy. Remember that we are only trying to "hedge" the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Note: Click here for further details about establishing a protective put position.

Building A Watch List of High Quality Stocks

As many of you know, our core investment strategy is centered around buying high-quality stocks at good prices. We use a combination of fundamental and technical analysis to determine which stocks to buy and when to buy them (learn more about our ratings methodology).

We created our ranking system to help us find the best dividend stocks. If you rank all of the stocks in a universe against their peers on a consistent basis, it becomes clear which companies are the strongest and which offer the best investment opportunities going forward.

We have written several popular series over the past month that have highlighted some stable, high-quality dividend stocks to keep on your radar:

While these lists are by no means exhaustive (there are literally hundreds of decent candidates out there), it should give you a great start on your diligence.

Establishing a "Buy Zone"

Just because a stock has a high rating in our system, it doesn't necessarily mean that you should run out and purchase it that day. Once we have decided that we want to purchase a particular stock, we look for a low-risk entry point to open the position. We call these entry points our "Buy Zones" and they are points at which long-term dividend investors should feel comfortable starting to build a position in the respective stocks. We focus on four key levels of support when determining a "Buy Zone":

  • Technical - Support from short and long-term trend lines (i.e., 10-week and 40-week moving average).
  • Volatility - Target correction levels based on historical volatility and maximum draw down.
  • Valuation - Support levels based on historical valuation multiple.
  • Yield - Support levels based on forward dividend yield.

We then average the low end and the high end of these key support levels to determine our target "Buy Zone". In other words, we use fundamentals to decide WHICH stocks to buy and we use a combination of technicals and valuation to determine WHEN to buy those stocks.

It should be noted that this is how we determine our "Buy Zones", but there are no right or wrong answers here. We encourage investors to think hard about the key levels of support for their own stocks. What is the valuation level that you would feel comfortable buying a certain stock? What yield level makes sense for you? Also, you may want to add different parameters that fit your investment style better. The key takeaway here is that you establish a consistent process for determining a "Buy Zone".

Summary

A healthy pullback is a great thing for the markets. In fact, a correction is the best time to take advantage of great stocks that are "on sale". In our opinion, the best way to prepare for a market correction is to make sure you have a list of stocks you want to buy as well as the price you want to buy them. If you have properly diligenced these stocks (and Buy Zone prices), you'll be prepared to "buy the dip" when it eventually happens.

Note that we just started our DIY Dividend Investors Club series which is dedicated to the open discussion and analysis of building and managing a long-term dividend portfolio. The goal of the series is to build a dividend portfolio "watchlist" by sector (based on the 9 major sectors in the S&P 500 as well as alternative sectors like MLPs, REITs and BDCs).

Please make sure to "follow" us so that you will be notified when each new article is published.

Source: 2014 Market Correction Survival Guide: Prepare For The Worst