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  • The answer is not to sell everything.
  • Rational analysis generally prevails over panic.
  • Corrections can be your friend.

On July 25, 2014, Stephen Mayo published a well reasoned and provocative article entitled "The Day I Sold Everything" which generated a great deal of interest and commentary. As a seasoned investor with a solid track record, I am writing to express another view of how to address the risks of a correction without relying on what amounts to an "all or none" strategy. But first a little background and commentary on the commentary that the article provoked.

I have been investing in the stock market for more than fifty years. I have gone through periods where I was trading frequently, periods of buy and hold, and mixed periods where I was trading perhaps twenty or thirty percent of my portfolio. I have been caught in the backwash of serious corrections, and I have reacted to them effectively in some situations and ineffectively in others. I have been wounded and I have celebrated and I prefer the latter. I don't claim to have seen it all, but I have seen a lot. This lifetime of lessons has taught me that precipitous moves, no matter how convinced we are of their rationality, are frequently ill timed, and that Mr. Market has a way of humbling even the most thoughtful trader.

I find the comments to Mr. Mayo's article fascinating. They range from folks who are active traders and feel that they can profit in any market, to long term investors who ride out the storms and simply keep accumulating positions as they are able. Most conspicuously, virtually none of the many commentators told us how much money they were dealing with and most of those that were critical, offered very little insight as to why they were resistant to any changes to their portfolios that might be responsive to Mr. Mayo's concerns. There was also a smattering of commentators who were lamenting the decline of the dollar or perhaps because of their political inclinations, were "ranting" on Fed or other government policies that may or may not induce corrections - they didn't generally say. In short, I didn't find the hundreds of comments particularly helpful in trying to mesh Mr. Mayo's concerns and particularly his actions, with my own experiences and concerns. I therefore felt that a separate article rather than a comment might be helpful to others.

I live in California. The effective tax rate on long term capital gains, considering both Federal and state, is about 28% in my brackets. When I look at my portfolio, I am not only in a long term capital gains position in most instances, but at least 50% of the overall current value is in unrealized capital gains. (I am not going to address the IRA and Roth holdings.) Thus, were I to liquidate in one shot, I would incur a tax liability of approximately 14% of my portfolio value. The market would have to correct by more than 14% before the market value loss would equate to the tax hit.

Of course, the argument repeats that the correction is likely to be deeper than 14% and once in cash, one can jump back in after the dust clears and be able to grab high value stocks at bargain prices and ride them up to levels that would overshadow any tax hits. The statistics are not so clear.

Barry Ritholtz maintains a blog called "The Big Picture" and he has distilled data from Dow Jones, Morningstar and Bloomberg to reach the following observations:

"√ Since the end of World War II (1945), there have been 27 corrections of 10% or more, 12 of which had turned into full-blown bear markets (with losses of 20% +).

√ This equates to one correction roughly every 20 months, according to Dow Jones index maven John Prestbo, who points out that this average does not mean they're evenly spaced out. 25% of these corrections over the last 66 years occurred during the 1970s (the Golden Age of Market Timers), another 20% occurred during the secular bear market of 2000-2010.

√ The average decline during these 27 episodes has been 13.3% and they've taken an average of 71 days to play out (just over three months).

√ From the beginning of the last secular bull market in 1982 through the 1987 crash, there was just one correction of 10% or more. Between the Crash of 1987 and the secular bull market's peak in March 2000, there were just two corrections, according to Ed Yardeni. This means that secular bull markets can run for a long time without a lot of drama.

√ Since the stock market's bottom in March of 2009, there have been only 3 corrections: In the spring of 2010 the S&P 500 began a 69-day drop of roughly 16%. The widely referenced summer correction of 2011 lasted for about 154 days and almost became a bear market. The correction during the spring of 2012 set up one of the greatest rallies of all time, although it was barely a real correction, sporting a peak-to-trough drop of just 9.9% in just under 60 days.

√ The most recent correction took place in 2011, between the end of April into the end of September. The Dow dropped roughly 16%. The S&P 500 actually dropped a hair over 20% before snapping back, leading some to believe that this was a bear market - the implication being that the current bull market is just 2 years old and not five years old (dating from March of 2009). I have no strong opinion on that debate.

√ Bull market rallies in between corrections - and there have been 58 in the post-war period - tend to run for an average of 221 trading days before being interrupted and gaining an average of 32%. By this standard, we are way overdue for a correction (but in fairness, we have been for awhile)."

I have quoted Barry at length because his comments show that the inevitable correction is most likely to be limited to a range of between about 9% to a high of 16%. While there certainly are exceptions, and there is always a risk of a wash-out crash, these figures provide a good estimation of the most likely scenario. However, very few corrections have turned into either a bear market or a crash.

Another point that I have observed over and over is that no one can tell when the correction has hit bottom and when markets turn, they turn fast, and those who have been sitting on the sidelines clutching their cash, are seldom able to time the reentry with any degree of precision. In my experience, most investors are very fortunate if they manage to gain 40% to 50% of the recovery. Mr. Market does not generally reward so-called market timers.

The financial press is full of articles predicting an imminent correction, and I would not be at all surprised if one materializes in the next several months. So, what should an investor do whose stomach is churning with this fear? The answer, I submit, is not to sell everything. This is an opportunity to glean from your portfolio those stocks that have run their course, that have disappointed, or whose prospects are not what they seemed to be when you originally bought them. Let's take these one at a time.

1. Stocks that have run their course. Don't try to do this analysis in your head. Set up a spreadsheet with each of your holdings, the original cost, the annual dividend income, and the current market value. Do your research. What do the analysts say about that stock now? Is there still substantial room for growth? Would you buy that stock today if you didn't already hold it, or would you add to an existing position based on its prospects measured from right now? If you can't justify buying the stock today based upon the fundamentals of the company and of its industry or sector, you should give serious consideration to selling it to build up your cash.

2. Stocks that have disappointed. Remember that gal you asked out 35 times in high school and she always had an excuse to say no? (Maybe that doesn't happen any more and I am dating myself, as it were.) You did your research, or you relied on your instincts or for any one of many reasons, you bought Company A. You have held Company A for months or years, always checking Seeking Alpha for another optimistic article, and you still believe in the story. Sure, Company A is up 8%, but everything else in your portfolio is up 20%. It is time to let go of the dream. We can't always pick winners.

3. Stocks that have changed their business and no longer have what attracted you in the first place. This analysis is similar to that in No. 1, but it is broader. Companies morph into other companies with different businesses either from organic change or by acquiring other companies. Sometimes these dramatic changes work out and sometimes they don't. I noticed that Mr. Mayo shed COP. The changes wrought at COP were dramatic and hugely profitable for investors. Not every story worked out that way. Sometimes the market environment in which the company is operating is undergoing a sea change and its prospects are no longer positive. If you have holdings in companies that have changed, that have acquired unrelated businesses in an effort to morph into something else, which have spun off businesses without adequate positive impact on the parent, or which are facing dramatic changes in their markets, it is time to let them go. (Best Buy (NYSE:BBY) is a good example.)

4. Downright losers. I have added this fourth category as hope springs eternal and there isn't one of us that didn't hold onto a loser confident that in another month or two it would turn around, we would be at least even, and upward and onward from there. It is tough to take losses, but in this process, the losses will offset gains and there will be a net benefit.

Stocks that meet the above criteria are more likely to be hit harder during a correction and are more likely to lag the market in the recovery. Once you have pruned them out, your portfolio is going to be better able to stand a correction, will most likely recover at or better than the market as a whole, and you will have put aside cash that will be available if you are able to catch the market bottom. You will not have incurred unnecessary income taxes, you will have retained the long term character of most of your positions, and hopefully, you will be able to sleep easier.

I will confess that the foregoing is part of "Stock Investing 101", but knowing something and being able to implement it are two different things. At some point, every successful investor comes to the realization that stock investing is not gambling and that investing in stocks has no resemblance at all to selecting bets on the craps table.

Disclosure: The author is long COP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: 'The Day I Sold Everything' - Au Contraire