When there is a fierce bear market, like the one that the crude oil (NYSEARCA:USO) and the oil stocks have been experiencing in the last five months, many investors are tempted to sell their stocks at a loss with the intention to repurchase them at a lower price. As the oil market is in a free fall, it seems very easy to sell today and buy later at a lower price. However, there are a number of reasons that render this strategy unsuccessful in most cases. To be clear, I refer only to stocks that have strong fundamentals and are likely to fully recover when the temporary headwind disappears; I do not refer to companies that have incurred a permanent deterioration in their business.
First of all, when one sells a stock in a bear market with the intention to buy it later at a lower level, one simply does not know how low the stock can go and when is the right time to repurchase it. Therefore, it is hard to execute the strategy properly. The worst thing that can happen is that the investor sells the stock near the bottom, when the market sentiment is the most bearish, and thus loses the whole rebound. This is not that difficult to occur, as the rebound from the bottom is always pronouncedly steep and offers minimum time to react.
Even if the investor does not have such a bad timing, strong bear markets usually include some strong relief rallies, which usually disrupt this strategy. More specifically, an investor who has sold a stock to purchase it lower usually capitulates after a strong relief rally and is thus psychologically forced to repurchase the previous holding at a higher price. As we all know, selling low and buying high is not a recipe for success.
A rule that should never be forgotten for the case of missing the train (failing to repurchase the stock) is that a realized loss is usually extremely hard to recover, particularly after a fierce bear market has run enough distance. For instance, when a 20% loss has been realized, then a 25% gain is required just to breakeven. Similarly, when a 50% loss has been realized, a 100% gain is required to breakeven. If the waiting time to breakeven is taken into account, it is evident that the investor will probably waste many years only to record a 0% profit on the initial investment.
A fact that becomes evident from the above rule is that there is usually asymmetric upside/downside after a bear market has run enough. More simply, the potential upside is much greater than the remaining potential downside. For instance, oil has lost about 40% in the last five months, now trading at around $62. From this level, the maximum reasonable (based on fundamentals) downside is about 27%, down to $45, while the maximum upside is about 65%, up to $102 (the level back in June).
The asymmetry is similar for the oil stocks, most of which have been severely beaten by the market. The table below shows the potential upside/downside of the following oil stocks: Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), BP (NYSE:BP), Total (NYSE:TOT), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), ConocoPhillips (NYSE:COP), National Oilwell Varco (NYSE:NOV), Schlumberger (NYSE:SLB), Ensco (NYSE:ESV) and Noble (NYSE:NE).
The upside of each stock reflects a full recovery of the oil price to its recent high ($102) and the resultant recovery of the stock to its recent high while the downside reflects a further plunge of the oil price to $45. For the calculation of the downside of each stock, I assume that each stock will incur a decline that is proportional to the decline that has already been realized due to the plunge of the oil price so far. This may not be precise, but it is a close estimate if we assume that the current price of the oil stocks reflects correctly the plunge of the oil price that has been realized so far. As a side note, I believe that an oil price of $45 cannot be sustained for long, as the demand will greatly exceed the supply at that level, but I use it as a worst-case scenario.
|Royal Dutch Shell||
|National Oilwell Varco||NOV||18%||37%|
To sum up, the asymmetrical upside/downside depicted above after a bear market has proceeded for long confirms that it is very risky to sell a stock in order to repurchase it at a slightly lower level. The investor who pursues such a strategy may miss the whole rebound or may be psychologically forced to repurchase the stock at a higher price after a relief rally within the bear market. Even worse, the investor may choose the worst moment to trade the stock, as the sentiment is the most bearish near the bottom when the perpetuation of the downtrend seems to be the only sure thing and most investors look at the wrong direction.
Disclosure: The author is long XOM, CVX, BP, ESV, NOV.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.