[Originally published 5/19/2014]
It takes minimal skill for an investor to make a profit in bull markets. After all, a rising tide lifts all ships. Stock picking and sector rotation become less important as indices mark new highs on a weekly basis.
The long bull market of the 80′s and 90′s gave rise to prominent investment experts who touted their strategies as the best way to make money on Wall Street. The popularity of the stock market gave way to Regulation Fair Disclosure, allowing everyday people to play the market and copy the methods of great investors like Jack Bogle, Warren Buffet, and Peter Lynch.
However, the tech bubble crash in the early 2000′s shattered the illusion that anyone can make easy money in the market. Some were able to pull out with only minimal losses, but many more lost everything they had put into stocks.
A question was raised. What did everyone do wrong? If they mimicked the patterns of successful investors, then why did so many people fail?
A case was made that the relatively stable market of the 80′s and 90′s made it easier to pick winning companies and make a profit. There’s some truth to that theory. A look-back at the $VIX over the last 20 years reveals a much more volatile marketplace post-2000 than it was in the 90′s.
The macro wasn’t to blame though. The real difference between successful investors and unsuccessful ones isn’t what type of market they’re investing in, it’s how they manage it.
Even in bull markets, corrections happen. They should be expected and taken into account when designing your investment strategy. The same easy-money methods that work when the market is seemingly in a perpetual upward climb will work against you when the inevitable correction occurs.
What goes up, must come down; booms are always associated with busts. One of the biggest mistakes in the financial crisis in ’08 was assuming that real estate prices would continue to climb into perpetuity – a nonsensical valuation that swept the rug out from under the feet of both professionals and non-professionals alike.
The Price-To-Earnings Ratio
One of the most-looked at ratios in the stock market is the price-to-earnings ratio (P/E). This tells investors how much of a premium people are willing to pay based on an underlying company’s earnings. If a company reports earnings of $2 and the stock trades for $25, then it would have a P/E ratio of 12.5. The higher the premium, the more growth is anticipated from the company.
This ratio also works to estimate overall valuations in the market. The mean average P/E for the S&P 500 is currently 15.51 so a figure lower than that could mean the market is undervalued while a higher number could indicate overvaluation.
Right now, the S&P 500 trades at 18.85 times earnings, clearly higher than normal, but don’t panic just yet. The average multiple may be higher than statistical averages, but it’s nowhere near the record high of 123.79 that occurred back in May of 2009. All we can glean from this information is that the market is slightly overvalued, but it doesn’t tell us how far valuations will climb until a correction actually occurs. We need more data for that.
The Business Cycle
The business cycle is the up and down movement of economic activity over a period of time. Throughout the cycle, various stock sectors wane in and out of favor giving way to investment strategies like sector rotation. These cycles usually last around six years with expansions lasting a bit more than five years and contractions just shy of one.
Investors can gauge the state of the economy by monitoring which sectors are performing well and which are lagging. The cycle is broken down into four stages: early expansion, middle expansion, late expansion, and recession. Here’s how the stock sectors perform at each stage:
- Early stage Out-performers: Financial, Consumer Discretionary, Technology, Industrial, and Materials
- Early Stage Under-performers: Energy, Telecommunications, Utilities
- Mid Stage Out-performers: Technology and Industrial
- Mid Stage Under-performers: Materials and Utilities
- Late Stage Out-performers: Materials, Consumer Staples, Healthcare, Energy, and Utilities
- Late Stage Under-performers: Consumer Discretionary and Technology
- Recession Stage Out-performers: Consumer Staples, Healthcare, Telecommunications, and Utilities
- Recession Stage Under-performers: Consumer Discretionary, Technology, and Industrial
If we look at how each sector has performed over the last year, we can see that the top three gainers are healthcare, industrial, and technology while the worst three are consumer staples, materials, and financial. The current bull market may be aging at five years old, but sector activities don’t clearly point to a single phase.
Exogenous influences can also impact the business cycle. Political changes like the Affordable Care Act has revamped the healthcare sector and the globalization of financial markets mean that actions from China and Europe can alter the landscape in unforeseen ways.
Looking at the data, we can see the market is slightly overvalued and the bull market has reached the end of its run based on averages while individual sector activity is mixed. It’s not a guarantee, but it should be safe to say that a correction is more likely to happen than not, so how do you position yourself?
Ways to Prepare for a Correction
Instinct tells us to remove ourselves from harm’s way if we sense a problem. The knee-jerk reaction is to pull our money out of the stock market and wait for the clouds to dissipate. If we look at the information blasted out of some of the largest money management firms though, it says that we should hold on and ride out the storm. They latch onto our fear of missing out. It may be a powerful motivator, but it doesn’t lead to the best course of action.
Long-term investment strategies are the staple of the financial world and with good reason. The average annual return over 20 years is between 7% and 7.5% if you stayed invested the entire time. One of the most oft-repeated statistics is how a portfolio would perform over a period of time given that it misses out on the best ten trading days.
A portfolio spanning 1994 to 2014 would’ve generated a greater-than-average 9.22% annual return based on the S&P 500 index. If it missed only the best 10 trading days, the annual return would’ve been cut down to just 5.5% – a 40% drop in performance.
It’s a galvanizing chart, but let’s analyze it from the opposite viewpoint. If our portfolio only missed the ten worst days in the market, we would’ve seen an annual return of 13.48% – a 46% improvement. Calculated as a comparison from missing the ten worst days, it’s an improvement of 145%.
Actions to Take
In actuality, market timing is likely to result in a mixture of both; missing both good and bad days. So unless you happen to have the worst luck of all time, you’re unlikely to miss just the best trading days. They key is being able to get out before the big down day happens.
Selling out of all your positions is a panicked response to a temporary setback. Investing in less-risky defensive stocks can help protect your portfolio from losses. Instead of panicking and selling, you can stay invested but in companies that pay dividends and provide protection with stock buybacks thereby limiting the drop possible in any given trading day.
Of course, there are several other strategies you can use to keep your portfolio staying profitable even when a correction happens while staying fully invested in the stock market.
Diversifying Against Risk
One of the easiest things you can do to prepare your portfolio against the unexpected is to diversify your holdings. Spreading out your investments across different sectors, sizes, and classes will help mitigate risk and ensure that weakness in one area of the market doesn’t infect your entire portfolio.
One of the fundamental tenants of Modern Portfolio Theory is that each investment holding you have should be as separate from each other as possible in order to keep risk at a minimum. You’ve probably heard the adage often associated with this concept, “don’t put all your eggs in one basket.”
One mistake investors made in the tech crash was to buy only tech-related stocks instead of balancing out their holdings with other sectors like energy, consumer staples, utilities, etc. If they only had a portion of their portfolio exposed to technology companies, the resulting crash wouldn’t have impacted them nearly as much.
You can accomplish diversification by making sure that you keep no more than 10% of your total portfolio in any one sector. It’s also a good idea to include a mix of varying sizes as well from large-cap blue chips to small-cap growth stocks since the larger companies tend to be more stable and less prone to extreme highs and lows.
One way of gauging a stock’s volatility is by looking at its beta. This will tell you how a stock moves in correlation with the overall market. If the beta is 1, it should behave in sync with the market. A beta greater than 1 means that it will experience more volatility than the general market, while a beta under 1 means the stock will experience less volatility.
For example, if a stock has a beta of 1.5, it means that it should experience 50% more volatility than the general market. Some stocks like utilities may have an extremely low beta closer to 0 which means that it will have almost no correlation to the market and very little volatility. If the market goes up, the stock may move upwards proportionately less, however, it would also lose less in a downward market.
Hedging Against Risk
Another way of protecting yourself from downturns is by utilizing option hedges. Selling covered calls and buying puts are a good way of minimizing potential losses without having to make any major adjustments to your holdings.
If you are expecting a correction, selling covered calls will help buffer your portfolio from losses. The premium you collect when you sell serves to lower your cost basis and your profitability break-point so the stock doesn’t have to regain as much ground after it drops.
Let’s say you own 100 shares of ABC which is trading at $50 and you want to hedge against any possible downturn. You decide to sell a call 3 months out with a strike price of $55 for $300. You’ve just lowered your break-even price to $47 so even if the stock fell 6%, you wouldn’t have lost any money.
Buying a put is another hedging strategy you can use with options. Instead of receiving a premium up front like selling a call, you purchase the right, but not the obligation, to sell a stock at a given price point. You can use this strategy to eliminate risk entirely for the time the option is in force minus the cost to buy it.
We’ll use the same example as before where you own 100 shares of ABC at $50. You purchase a put option for 3 months out with a strike price of $50 for $300 and watch as the market suddenly takes the dive you thought might happen. Even if the stock ends up at $0, the most you could lose is the $300 cost it took to buy the put.
Taking the fear out of investing will not only help you sleep better at night, but could also save you a lot of money as well. Remember that all downturns have a limited lifespan and can provide additional investment opportunities for you.
If a stock you own has taken a hit during a correction, you may want to consider buying more shares at the lower price. Not only will you be able to add more to your position at a lower price, but like selling a call, it will also help to lower your cost basis and break-even point. Stocks can fall for many reasons unrelated to company performance. Don’t let fear rob you of the opportunity to buy the stock at a discounted price.
The best thing you can do is to stay aware of your surroundings. Corrections are difficult to spot, but maintaining a disciplined investment philosophy will keep you protected at all times. Diversification and selective options hedging ensures that your portfolio is well insulated against volatile price movements.