As political campaigns ask the question about a presidential cycle, the completion of a market cycle behooves us to ask the same of our investments. While the economy is arguably still in recession, we can see that the market has gone full cycle: from the record highs to the crash and we are once again approaching those highs.
Click to enlarge
Despite a small capital loss, index investors are slightly up as compared to the previous high due to dividends. Active investors show a much broader range of results. Prevalent pitfalls and unprecedented opportunity have separated those who invest intelligently from the rest of the pack. Let us take a look at what happened in this last cycle so as to gain insight as to how to come out ahead in the next one.
A key theme throughout the cycle, particularly in times of high volatility is the disproportionality of price movement. This is a tremendous source of opportunity that we can capture by repositioning into the undeserving laggards. To clarify, what I mean by an undeserving laggard is a stock which has not performed as well as it should have. Unfortunately, there is no equation that can find these opportunities for us, but there are two things we can do to increase our chances.
1) Constant revaluation of a broad spectrum of stocks alongside tracking of their market values can spot disparities between price movement and performance.
2) Examination of the previous cycle's undeserving laggards to gain insight as to where opportunity can appear.
For simplicity, we will separate the market cycle into three phases: Full valuation, crash, and recovery. To maximize our chances for outperformance, we must know how to react to each phase, while recognizing that we cannot predict the onset.
In hindsight, we would have been benefited by divesting before the crash of 2008, but most investors did not and could not see it coming. More practical advice as the market reaches full valuation is to have a well-diversified portfolio trading at reasonable values. This simultaneously allows for gains if the market continues an upward trajectory, while mitigating damage in a crash. Theoretically, a perfectly diversified portfolio will crash equally as hard as the market. Then how does it mitigate damage? The answer is that it affords repositioning during the crash and recovery phases.
During a crash, we want to avoid being one of the thousands of panicking investors selling into a void, but at the same time, it seems equally bad to hold on to our stocks as they hit rock bottom. This is where diversification comes in. Highly volatile markets almost always create disproportionality, so we can greatly reduce our losses by selling the undeserving outperformers in our portfolios. Undeserving outperformers refers to stocks that have performed better (or in this case fell less) than they should have. This opportunistic divestment frees up the capital for the phenomenal opportunities that inevitably occur.
As an example, I will show what we, 2nd Market Capital, did during the crash of 2008. It so happened that preferreds almost across the board fell disproportionately more than their respective commons. This disproportional drop was completely unjustified, since preferreds should perform better than commons during a crash, as they are superior in the capital structure and accrue dividends, rather than investors losing them. However, a lack of market awareness and incredibly low volumes caused the preferreds to simply have no buyers such that even a few panicking investors could cause the price to fall off a cliff. The opportunity was clear, so we began repositioning within companies, selling our common stock in favor of the preferred.
Annual Yield at cost
Ashford Hospitality Trust (NYSE:AHT)
Series A Preferred
First Industrial Realty (NYSE:FR)
Series J & K
$11.30 & $11.50 respectively
16.04% & 15.76%
Glimcher Realty Trust (NYSE:GRT)
Series F & G
$9.58 & $10.34 respectively
22.83% & 19.64%
Lexington Realty Trust (NYSE:LXP)
Series B Preferred
Strategic Hotels (NYSE:BEE)
Series C Preferred
During the recovery phase, investors can reap the rewards of the intelligent repositioning done during the crash. More repositioning can be done here, but with the lower volatility, fewer extreme opportunities will arise. Instead, emphasize value. If the fundamentals of recovery are strong, leveraging up a portfolio (particularly with the low cost as of late) can be quite conducive to outperformance.
Following up on the common to preferred arbitrage that we used during the crash, let us see where these issues stand now.
Recent Market Price
FR-J & K
$25.09 & $25.01
122% & 117%
186% & 180%
GRT-F & G
F redeemed at $25 & $25.33
161% & 145%
246% & 223%
Redeemed at $25
*Approximated 4 years of dividends (less for those redeemed)
The market has gone full cycle returning us to a period of full valuation. Honestly, I have no idea as to whether the market will keep going up or if the next crash is imminent. Delevering and diversifying provide solid footing for whatever may happen.
In summary, knowledge of previous cycles, coupled with a diligent awareness of a broad spectrum in the market will greatly aid in the pursuit of outperformance.
Disclaimer: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.