In A Downturn, Ignore The Pundits And Stay Aggressive

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 |  Includes: DIA, QQQ, SPY
by: Vince Martin

The markets seem to have come to the agreement that, yes, we are officially in a downturn and the only argument now seems to be just how deep we will go. And while I have argued recently that 2011 is not 2008, it still seems worthwhile to review stock performance in our last big downturn to prepare our strategies for the one we are in.

It is conventional wisdom, replayed endlessly online and on television, that in a market downturn, investors should turn to "quality stocks that are on sale." This advice is asinine for two key reasons:

  1. The direction of the broader market has nothing to do with purchasing "quality stocks". Does this mean that in bull markets, we don't have to worry about the quality of our stock purchases? (Some might argue that is EXACTLY what many stock pundits mean, but I digress.) The advice to "purchase quality stocks in a downturn" is a cliche, a trope, a copout. It belongs with gems like "Well, it'll get better with time" and "There are plenty of fish in the sea."
  2. Commentators seem most often to define "quality stocks" as blue-chip dividend payers. And while companies like McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ) certainly qualify as "quality stocks," they are precisely NOT the type of stocks investors should buy if they are attempting to time the bottom of the market.

Let's take a look at the market from March 6, 2008 to March 5, 2010 (3/6/10 was a Saturday), with a one-year bracket from the intraday low on the S&P 500 of 666, set on March 6, 2009.

Returns Before And After 3/6/09 Bottom, By Sector
Ticker (Sector) 3/6/08-3/6/09 3/6/09-3/5/10 2-year Return
DIA (Dow Jones) (44.96%) 59.44% (12.24%)
SPY (S&P 500) (45.34%) 66.31% (11.16%)
QQQ (Nasdaq 100) (37.30%) 76.97% 10.96%
MDY (S&P MidCap 400) (45.63%) 88.19% 2.32%
SLY(S/P SmallCap 600) (49.35%) 109.21% 5.97%
GLD (Gold) (4.36%) 20.06% 14.82%
DGT (Global Titans) (46.51%) 58.36% (15.29%)
DVY (Dividend Stocks) (49.25%) 70.33% (13.55%)
SDY (S/P Dividend) (41.17%) 75.86% 3.46%
XLF (Financials) (71.36%) 133.66% (36.26%)
XLV (Health Care) (28.78%) 45.04% 3.30%
XLU (Utilities) (35.64%) 32.96% (14.42%)
XLP (Cons. Staples) (25.14%) 41.90% 6.21%
DEF (Defensive Stocks) (38.56%) 54.78% (4.90%)
XLK (Technology) (36.97%) 64.63% 3.77%
XSD (Semiconductor) (36.75%) 103.78% 28.45%
XBI (Biotech) (12.65%) 34.03% 17.07%
GMM (Emerging Mkts) (52.66%) 96.41% (7.01%)
IWC (Microcaps) (50.37%) 92.55% (4.45%)
XLE (Energy) (47.70%) 51.40% (20.82%)
XPH (Pharma) (19.35%) 69.23% 36.49%
MXI (Basic Materials) (58.18%) 95.43% (18.27%)
RWR (REITs) (59.66%) 115.86% (12.93%)
Click to enlarge


(ed. note: these figures do include ETF distributions [with the exception of DJIA], but does not assume that those distributions were reinvested. Gathering this data was time-consuming enough. Historical prices taken from marketwatch.com.)

What do we learn here?

1. In a broad market downturn, there was nowhere to hide. The oft-advised strategy of turning to "defensive stocks" -- consumer staples, health care, defense contractors, utilities -- in times of volatility did little to help investors in 2008-09. On a sector basis, they did outperform the market. However, losses of 35% in utilities, 25% in consumer staples, and 29% in health care show the limited ability of defensive stocks to combat a broad and deep, market downturn. Moving to cash, using hedging strategies such as covered calls on individual stocks or ETF's or simply hedging one's entire portfolio using index options are far more effective strategies for investors attempting to time the market and prevent or limit losses. These strategies can be costly and difficult to time, but so is sector rotation.

2. Speculative stocks rebound stronger. This is somewhat common sense, of course, though often forgotten in the fear of a downturn. Look at the 7 sectors returning over 90% in the year following the March 6th bottom:

Sectors With a 90% Rebound off March 6th Lows
Ticker (Sector) 1 yr return
XLF (Financials) 133.66%
RWR (REITs) 115.86%
SLY (Small Caps) 109.21%
XSD (Semiconductors) 103.78%
GMM (Emerging Mkts.) 96.41%
MXI (Basic Materials) 95.43%
IWC (Microcaps) 92.55%
Click to enlarge


It's ironic to note that the two leading sectors -- financials and REIT's -- were both considered defensive sectors prior to 2007. (It should go without saying that no analyst was promoting the defensive value of either group in 2008-2009.) And both sectors were the hardest-hit during the market decline starting in 2008. Indeed, triple-digit returns were not enough for either ETF to return to March 2008 levels. The other groups in our list either lean speculative (small and micro caps, emerging markets) or cyclical (semiconductors and basic materials).

So investors confident that we are at or near a market bottom now shouldn't be looking just at ExxonMobil (NYSE:XOM) or Google (NASDAQ:GOOG) or other industry leaders. I've written before about contrarian plays in the semiconductor industry; with the Philly Semiconductor Index (SOX) down 31% from February highs, investors can look to be greedy among the fearful, to paraphrase Warren Buffett. This is the time to look at small-cap technology stocks, or leveraged shipping lines, or consumer stocks facing an uncertain economy. Risk-tolerant investors might even consider financials -- yes, financials -- given their success in the 2009 rebound. These are the companies -- companies who need to finance debt, companies with undeveloped products, distressed consumer stocks -- who are most subject to the whims of the broader economy, and who will profit the most should the market forecast happier days.

3. Big names lag in a recovery. The 2009-10 returns of the Dow Jones, DJ Global Titans (an index of 150 global blue chips), and the SPDR Energy ETF all trailed markedly against the broader market, tech, and smaller companies. In the year after the market bottom, La-Z-Boy (NYSE:LZB), Ruby Tuesday (NYSE:RT), EW Scripps (NYSE:SSP), JDS Uniphase (JDSU), and Dollar Thrifty Automotive Group (NYSE:DTG), all established brands, saw their stock price rise by over 1000 percent. Compare those gains to the 38% return from Johnson & Johnson (JNJ) or the 26% returned by McDonald's (MCD). Returns over 25% are nothing to sneeze at, but the true allure of downturns is in the 3-, 5- and 10-baggers. It's easier said than done to pick these stocks ahead of time, but rest assured that no matter the depression and no matter the recovery, you won't find 100%-plus returns in established blue chips.

4. Dividends are not the answer. Even including dividend distributions, traditionally high-yielding sectors such as utilities and REITs struggled, with both trailing the broader market over the 2-year span. The two dividend ETFs profiled bracketed the S&P 500 on the way down; SLY wound up outperforming while DVY underperformed, with both trailing tech, small caps and mid caps on the rebound. Even the impressive rebound in the REIT ETFs in 2009-2010 was caused almost solely by capital appreciation, as distributions accounted for only 7 of the 115 percentage points in returns.
The idea that dividends somehow hedge market falls ignores the fact that dividends are deducted from the stock price. Sold calls and bought puts can hedge a portfolio; dividends can only provide income. Furthermore, in times of panic, dividend cuts lead not only to income losses but capital losses, as they are almost always accompanied by stock selling. A look at dividend distributions pre- and post-market bottom:

ETF Distributions, Pre- and Post- 3/6/09 Market Bottom
Ticker (Sector)
3/6/08-3/6/09 3/7/09-3/5/10 % Change
SPY (S&P 500) $2.72 $2.18 (19.8%)
DVY (Dividend Stocks) $2.41 $1.66 (31.1%)
SDY (S&P Div. Stocks) $2.21 $1.73 (21.7%)
XLU (Utilities) $1.24 $1.27 3.4%
XLP (Consumer Staples) $0.65 $0.65 0.0%
DEF (Defensive) $0.50 $0.56 6.0%
RWR (REITs) $2.88 $1.98 (31.3%)
DGT (Global Titans) $1.95 $1.46 (25.1%)
Click to enlarge


The last on the list is best proof of the failure of dividends in downturns, as an index of 150 blue-chip, long-term, best-of-breed companies, still cut distributions by 25% year-over-year. Meanwhile, note that XLU and DEF boosted distributions, yet still trailed the broader market badly on the rebound.

5. Don't throw asset allocation out the window. One of the issues with writing for a broad audience is that equity portfolios do -- and should -- have vastly different allocations depending on goals. As a 32-year-old (yes, I am 32, the picture's old and I have a baby face), my goals of growth and capital appreciation may be markedly different from investors nearing retirement who are focusing on capital preservation and/or income generation.
Yet those investors, looking to rotate into more conservative equities, might have rotated right around the bottom, moving into "defensive stocks" on the way down, avoiding only a small amount of losses relative to the broad market, while losing the stronger rebound of technology, smallcaps, and emerging market stocks on the way up. Just as it is important not to overweight a portfolio with speculative plays into a market downturn, there can be a cost to overemphasizing a portfolio's conservative bent in a broad market recovery.

To summarize, I'm not necessarily predicting a market bottom right here; my gut feeling is that we still have some bulls to wipe out before the correction is complete. But those investors looking to be aggressive in the market should remember to actually be aggressive. If you have the tolerance to take on risk, and you are confident in your ability to time the market, there will be profits to be made. Look at option trades as well; 30% appreciation in a stock portfolio is nice, but that gain can be doubled or tripled with some well-chosen LEAPs. Most importantly, remember that if you truly believe a downturn has created buying opportunities, those opportunities are most likely where others aren't looking.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have long stock and option positions on semiconductor stocks in the SOX index, which is recommended here.