Will the Market Keep Falling? I Hope So

Some of my readers have asked me if I would be afraid if the market would continue falling to 50% or greater. I’m sure to their surprise, my response has been “I hope so”.

It is human psychology that leads us to believe that buying in a market where prices are up 300% is safer than buying when the market is down 80%. When markets are dramatically up, there is a sense of confidence in the air, when the markets are severely down the confidence is replaced with fear.

If we look at the past decade, many investors missed the chances to buy stocks following the .com crash, 9/11, Tsunami, SARS and now the credit crisis. Many investors I knew felt more comfortable buying Pets.com stock at its height instead of buying Amazon (AMZN) when the Nasdaq crashed 80%.

In addition to my typical look at high cash, low debt, high ROE and high ROI, a few simple rules should be stuck to when buying during a market crash.

1) Stick to big names and blue chips stocks.
2) Find companies that have built irreplaceable business models, distribution, infrastructure, support networks and brand names.
3) Buy low and don’t be afraid to buy lower.

By far the credit crisis is the most globally widespread of the problems we have faced since the Nasdaq crash. If the markets continue to fall, there will be a chance to start building positions in American Express (AXP) that has built an irreplaceable transaction network, or FedEx (FDX) and UPS (UPS), that have built irreplaceable shipping networks.

Pessimism will always pass, and when it does, the stock market will rally back to previous highs and onward to new highs. If you invest in a basket of stocks, there is always the chance that a few will go out of business. You should keep in mind though, that as long as your remaining stock investments recover to previously set highs, you will recover your losses. The discount to previously set highs is your hedge.

Let',s say you buy 10 blue chip stocks at a 50% discount. If 5 go out of business and 5 recover to original levels you break even. If you buy at a 60%, 70%, 80% or greater discount, your hedge grows. At 80% off previous highs, if you bought 10 stocks, 8 can go out of business and if 2 recover you will break even. The odds are squarely in your favor.

As readers have followed along with Raw Greed, investors know that I often recommend stocks when they have fallen 60% or greater and I’m not afraid to recommend buying more to lower your cost basis. Alternatively, if you’re not sure what to invest in during a market crash, buy an index fund.

Remember that a solid company makes a solid investment long-term. The fun of investing is buying at a discount to what you consider fair value. When broad markets sell off its easier to find those opportunities than when broad markets are setting new highs.

*Disclaimer: The author does not own a position in any of the stocks above.

Comments

[Umm, yeah]

All right - this article helps explain your logic of using Gold/Silver vs the Airline industry as hedges against each other.

I know that I don't have the temperment to invest this way, but it's good to read about a different philosophy. Thanks.

[Bear Stocks Report]

Why not just short-sell stocks like NCMI, TMX, ARGN, AXL, PACW and make profits now instead of waiting for the turnaround?

[gordo]

very nice article, I like to buy exellent businesses with durable competitive advantage run by first class, honest managers at a reasonable price. When a great business like American Express can be purchased fractionally at say $44/share instead of $66/share one has a much better margin of safety inherent in their investment. I just bought AXP at $43 and change and do feel good about the investment. The real goal as an investor is to avoid buying poor businesses at what seems to be "good" prices.

[CAraver]

Gordo was Enron a great company the week before they went under. What about Bear Sterns?
Amex could well be hit by credit defaults in the upcoming year... not sure that I would touch this with a barge pole as it could well be part of the portfolio that aren't winners!

[User 131753]

1). "Stick to big names and blue chips stocks." Are those like C, BAC, BS, GM, PFE big names/blue chips stocks?
2). "....have built irreplaceable business modeals...." Were those like ARBA, CMGI, NT, YHOO conceived as such?
3). "Buy low and don't be afraid to buy lower." Is our author talking about average the loss? If so, its' a bad idea and practically, nobody can do it on 10 stocks since we all have limited capital.

I think our author has a bullished bias toward the market, but to preaching "buy low & buy lower" is worse than buy & hold. If a stock dropped from $300ps to $150ps to $75ps to $37.50 to 18.75ps, there's someboy who bought at $37.50ps then at $18.50ps, the average cost is $28 but the base is $18.50, how long the guy has to wait till the stock comes up 34% to $28? Isn't it that one could have made very good money in short along the way?

Leon

Leon

[rawgreed]

Leon assuming that $300 was the high price of your stock, I wouldn't have started to buy until the stock hit a 70% discount i.e. $90.

For a blue-chip stock the odds of dropping to 70% are low, not to mention 80% or even 90% off of previous highs. If you play the short game you are betting on further downside after the stock has already dropped 70% or greater. No one knows where the bottom is, so it makes no sense to try and short an investment that you believe is a quality one at $300 or at $90. None of your examples above are quality examples. ARBA, CMGI, NT and YHOO built business models from networks and services that were relatively new and untested.

A better example would be INTC or MSFT in the tech sector. Picking up either of these at 70% or greater discounts would be a solid buy.

[kotika98]

When a solid stock goes down 50-60% you must assume that the sellers know something you do not. Just to inject a bit of common sense into this unrealistic discussion...

[alajac]

Andy, you must be very, very rich to have a timeline of basically "forever" to see your calls work out (besides the gold "nut" that the blind squirrel found). Not all of us are so fortunate and we must work on being correct in a much shorter time-frame. I thought SeekingAlpha had some standards concerning their bloggers; guess not.