December's Flight to Quality

December so far seems to be witnessing an unusually extreme version of its yearly flight-to-quality. This is not surprising, given volatility in the markets. This means that investors are buying big stable companies (like GE and Microsoft) and selling other stuff. This also means that the broad market indexes are not reflecting the volatility of the typical stock.

When investors are scared or facing a recession, they move into defensive and high quality stocks. Thus, mega cap, utilities, staples, and other non-economically sensitive stocks move up in price (or don't go down). However, just as recessions tend to be temporary, the move into high quality stocks tends to be temporary. The trend usually reverses itself once the recession bottoms. Indeed, the high quality stocks sometimes are the last to sell-off severely in a bear market.

Should we try to trade on this trend? If one has confidence in one's ability to predict recessions and market bottoms, then, by all means, trade away. If I knew how to do that, I would have no need for a job.

Instead, I stick to what I do know. Buy stocks that are cheap, and sell ones that are expensive. And there are a lot of cheap stocks out there.

I hesitate to use the following analogy, since so many have been hit hard recently in this area. But, fortunately, I do not live in an area of the country that was hit by the real estate bust (we didn't benefit from the boom, either). Nevertheless, I am not checking the comparable home sale prices every day on my house to determine if I am richer or poorer that day, and wouldn't even if I could. I know, however, that in the fall selling prices in my neighborhood usually decline about 5-10% from the previous summer. If I were to sell my house, I would try to avoid selling it in the fall, and instead put it on the market in the spring or summer. If I were to buy a house, I would try to do the opposite. Of course, houses are more than just investments - we live in them - and we don't always have control over our timing.

But stocks are investments, and if we structure our portfolios correctly then we can always have control over when to sell and when to buy. If I am not selling my stocks, then what do I care what the trading price is today or tomorrow. I only care about that when I decide to sell. I have enough liquidity in my portfolio that I have no need to sell and could buy more if I wanted to, even though I have a need for cash withdrawals over the next few months.

What does this mean for someone like me? Not much, except that I'm trying to profit off of the excessive volatility - buying stuff that goes down and selling stuff that goes up, or, when practical, writing options that effectively do the same.