Recent equity volatility should really come as no surprise to investors. Historically high valuations, a continuing stream of "bubblish" commentary and considerable disagreement over global macroeconomic conditions again seems to be coming to some sort of head. If we look back at the history of major market corrections, however, investors have been amply rewarded by stepping in and buying when fear envelops the market. When the next severe correction occurs, not just the dip we are currently experiencing, it will likely represent another robust opportunity for investors.
I agree with most of what Chuck Carnevale had to say in his latest need-to-read article that highlighted how long-term investors should separate the trees from the forest when it comes to looking at stocks during "frothy" markets. However I am in partial disagreement with the final bullet point he noted in that article, namely:
The broad market has nothing to do with the performance of individual stocks.
As we look long-term at markets, I think his statement is correct. And his evaluation of the varying performances of three stocks - Ross Stores (NASDAQ:ROST), AT&T (NYSE:T), and General Electric (NYSE:GE) - illustrates the different paths that those three stocks have taken since 2006.
But I would argue that over the near term, especially during periods of downside volatility, the broad market has a high level of correlation to the performance of individual stocks.
I want to draw your attention to the two last deep corrections that occurred in the market, the latest one, in 2011, based primarily on eurozone concerns, and the more serious one that brought our financial system to the brink of disaster in '08-'09. In 2011 the S&P 500 Index, as measured by SPY dropped almost 20%, while in 2008-09, SPY took a roughly 53% hit from peak to trough, even worse if we measure back to peak levels in 2007.
In the case of the 2011 correction, it took the S&P only 6 months to recover back to peak levels, while it took 4 years for the market to recover after the financial crisis, 5 years if we look back to peak 2007 levels.
I wanted to know what happened to GE, ROST, and T, compared to the broader market during the corrections, so I examined their pricing - peak to trough - to determine correlation and found the following:
|Stock||Peak '11 Price||Trough '11 Price||% Loss|
|Stock||Peak '08 Price||Trough '09 Price||% Loss|
All things considered, at least for these three stocks, there seemed to be a high correlation between how they behaved from peak to trough during the corrections. While the performance certainly wasn't exact, in all six occasions considerable price drops occurred relative to the drop in SPY. In the case of Ross, due to its robust growth trajectory, the stock quickly bounced back from the corrections (red oval), and was considered mildly undervalued by Chuck's F.A.S.T. Graph system in both instances.
In the case of GE, the stock behaved considerably worse than SPY in both corrections. In '08-09 its GE Capital division was saddled with toxic debt and the dividend was slashed. In 2011, the company appeared already mildly overvalued by Chuck's system, so a better-than-market decline might have been anticipated. GE has only now rebounded to 2008 trading levels and is still 50% lower than levels it saw during the growth stock mania of the late 90s.
Stodgy old AT&T showed corrections roughly in line with the market in both cases. Recognition of its slow growth trajectory has kept the stock's price at bay following its dive during the fiscal crisis. Today, the stock appears mildly undervalued in Chuck's system.
I looked at many other large-cap stocks and the theme basically repeated itself by varying degrees. So my general thesis is that the broad market has a lot to do with individual stock performance over short-term time horizons that involve sharp market corrections. Unless there is something particularly positive going on with a company that would enable it to dodge a broad market firestorm, it won't likely escape it. When the market decides to re-price on a wholesale level, it takes no prisoners.
Correction Strategy For Income Investors
Whether you want to manage an income portfolio, or any other portfolio for that matter, by making predictive moves or timing calls is up to you. In general I agree with Chuck that no one can consistently, accurately time markets. But, he and I disagree on whether holding or "raising" cash is an appropriate portfolio management strategy. I think an investor should always have at least a modicum of cash around to take advantage of attractive entry opportunities - especially when there is a "feel" that the markets are vulnerable. He believes for the equity portion of a portfolio, one should always be fully invested.
In any case, absent Nostradamus-like capabilities, what should income investors be doing during market corrections? For some, the answer could quite possibly be nothing. If one is invested in solid dividend growth companies with payout cushions, market volatility may do nothing to the income stream. Even during the horrendous sell off five years ago, many companies that find themselves in dividend growth portfolios today had no income interruption. Higher yielding equities, as well as banks, REITs, and leveraged securities, in general, did not hold up as well.
So for those that don't want to actively manage a portfolio even during market volatility, it's possible that it may be business as usual. A diversified group of well valued, low payout dividend growth stocks would seem to be a solid defense during volatile market spells.
For other income investors, downside volatility may present opportunity. And there may be opportunity in a variety of ways. First, as we all know, equity yields go up as stock prices go down. During corrections, given my general thesis, favored equities will likely trade at more attractive valuations and at higher yields. If there is cash on the sidelines, it can be put to use either by purchasing new equity at attractive yield or adding to existing positions.
For those without cash, all is not lost. Take the opportunity to assess holdings and upgrade a portfolio. If they are present, consider harvesting losses in unqualified accounts and rotate into equities with cheaper valuations, higher yields, or better dividend growth potential.
Or look at it another way. Since there may be wide disparity in equity performance during a correction, pare or sell stocks that hold up better and purchase or add to stocks that have gotten hit harder in order to increase overall portfolio yield. Of course one could take the perspective that the stocks that hold up well during corrections are ones poised to outperform the market going forward and should not be sold. Still, for the investor less concerned about capital than about income generation, this may be a wise consideration.
Increased volatility may also represent a good time for income investors to consider selling options, especially put options. As downside market and individual stock volatility ramp up, option premiums also ramp. Assuming you think that a stock will eventually bounce back, selling out of the money, cash secured puts is an excellent way to pocket premiums and potentially enter stocks at net lower levels. If your stock bounces back prior to expiration, you pocket the premium. If the stock falls in the money (below the strike price on the put), you may be assigned the stock and have to buy at the strike. There is not an absence of risk here though. When you have second thoughts about an option position, runaway downside moves may make exit difficult and costly.
While buy and hold income investors are generally prone to having their eye on the long-term when purchasing securities, it should be noted that sharp market corrections and valuation re-pricings don't seem to spare even the most durable of companies. During these typically volatile events, which could last for many weeks, months, or even years, investors tend to make mistakes - selling at the most inopportune of times or otherwise abandoning solid long-term investment principles. Though the latest selling dip may turn out to be just that, if it turns out to be something more, prepare to take advantage of it, and not be overwhelmed by it.
Disclosure: The author is long ROST, GE. 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. Author is also short AT&T puts.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.