(Source: The Freedom Trader)
"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."
Many investors take this quote as Warren Buffet unequivocally supporting "buy low, sell high." Chuck Carnevale recently wrote an article that in essence pushes this idea further forward in an atmosphere of fear. Reading that article, one specific statement struck me as needing a response:
"The time to liquidate stocks is when they are high or overvalued, not when they are becoming attractive."
My main concern with this statement is the implication that stocks are no longer overvalued. Yes, the market seems to have corrected itself, but at present we cannot be certain whether this is a correction in a continuing bull market or the first hiccup of a bear market. Thus, the Carnevale's article holds a connotation that can be dangerous in the latter case: a call not to sell stocks at a possible high, instead holding on in the assumption that stock prices are now fairly or under- valued.
Immune to Fear
Today's investors- especially the informed investors at SA- are increasingly immune to fear. In this new age of multimedia, we've been constantly bombarded by articles, blogs, and online videos attempting to trigger our fears. These marketing attempts might have worked in the early years of the Internet and continue to work on newer investors but fail at attracting the eyes and ears of investors who have seen these messages too many times to count.
But this phenomenon has its dark side: Investors overly willing to side with optimistic outlooks. I agree that using fear to attract the attention of investors is a slimy marketing practice… except when it isn't. Once in a while, we should be concerned about negative market conditions.
Carnevale urges investors not to liquidate- not to buy into fear- but sometimes liquidating is the right choice. "Buy low, sell high" implies that you know what is high and what is low. In the current market, the price of IBM, for example, can be considered both high and low, depending on your time horizon: Looking back to 2008, International Business Machines (NYSE:IBM) is high, trading at 300%, but reflecting upon the last year, IBM is at a relative low.
If you do not consider $120 to be high, then you must be assuming that IBM will rise in value. Likewise, if you are expecting a bear market- as many of us are- then $120 seems quite high for IBM, and liquidating the stock would be "selling high," not "giving into fear." That is, selling now is an intentional attempt to lock in a profit; this can be a logical choice completely separated from any notion of fear.
One thing I have noticed in all of the comments sections of the "Breaking News" articles related to market troubles is the common misconception of how a market correction works. In short, many investors assume that if this is a market correction we are seeing, the market will automatically bounce back after the correction. This is simply not true.
A market correction does not necessitate a rebound. As its name implies, a "correction" simply returns stocks to their fair-valued levels. This means that a correction should be followed by a flat market, barring other economic happenings.
If you truly believe we are seeing a correction, you must ask yourself whether this is a correction within a bull market - in which case the market does not bounce back but simply continues a trend - or if it's a correction at the end of a bull market. If the former, we should reevaluate the reasons for the current bull market.
Those reasons, as I previously mentioned, are highly related to artificial price increases in the stock market: the Fed pumping money into stocks and companies buying back their own shares as a result of not knowing how else to spend their cash. Thus, if we are to assume that the correction has finished, placing us at a fair valuation within a bull market, then the bull trend should only continue if those reasons are still in play. In other words, ask yourself whether the catalysts for this bull market that began in 2009 are still at work: Is the Fed still pumping money into stocks? Are companies still initiating buyback programs?
This Correction: A Misalignment of the Fundamentals
I am of the belief that this market correction is at the end of a bull market simply because investors are increasingly recognizing the fact that the market's fundamentals and the numbers we see next to stock tickers have come out of alignment. Investors keep the market afloat, as - unlike traders - they hold positions overnight. As investors take their money out of stocks, traders continue to play intraday trades, contributing to volatility, but they do not contribute to any upward momentum.
Of course, the catch is that liquidating your "high" positions equates to contributing to putting the brakes on this bull market. But investing is intrinsically a selfish game. You want to optimize your profits without much concern for that optimizing's effect on the overall market.
If you know that the catalysts for the bull market have artificially moved prices up to the tune of 20% to 30%, you would benefit from selling before we see a drop of such caliber. And then, the time to buy is not after the 20% drop but after the 20% drop and indications that the market will resume a bullish pace. Anything less and you're gambling.
Cash: What Is It Good For?
Of course, once liquidated, your capital is merely a number in a brokerage account. That number is useless unless placed in a vehicle in which it can appreciate. This is why I do consider liquidation as a single-step process.
Instead of reducing an equity-heavy portfolio to a cash-heavy portfolio, you should pivot on your investments. If world growth is truly on the decline, this has implications for the stock you are about to liquidate. And holding that stock, you likely know quite a bit about the company.
Use this to your advantage. Develop both a best-case and worst-case scenario for that stock. Take Apple (NASDAQ:AAPL) investors, for instance. They likely know enough about the value of the brand, the products, and iOS to find a minimum valuation for the stock.
Once you find that minimum, the next step of liquidation takes place. While the die-hard investors and fanboys watch their hands bleed down the falling knife, you convert your shares to cash. Now, you can leverage your knowledge of AAPL to gain income.
That cash you just received via liquidation is your "Apple Cash." It has a specific purpose: It sits in a margin account. In that margin account, you use said cash to hold against naked puts, which you sell out of the money, below the minimum valuation you obtained.
One day, you will likely have strong reason to be bullish again on AAPL. Now, you can buy back any outstanding puts and get back in with all your Apple Cash, only with more shares due to the income from the naked puts. Your cash, which merely sat in your account allowed you to reenter your position at a net gain in shares.
Moving forward, I do not predict a continuation of the bull market. Nor do I - in the short term - see a bear market. This puts me in a third, much less common camp than the "it's just a correction" and "the sky is falling" folks. I think for the next half year we are headed for a time in which we see stagnation in the stock market.
Though the fundamentals say bad things about world economic growth, the fundamentals are still better than they were in 2008. The next half year will be in the hands of traders, hedge funds, and algorithms. The market will remain as volatile as we see it now but we will not witness a single directional momentum.
Barring a war or a debt bubble, the economy of the United States is still strong enough to attract investors from within and abroad. As stocks become "underpriced," investors will enter (or re-enter). As more bad news arrives, investors will ditch their investments.
This results in a phenomenon of stocks hitting certain levels (defined by company valuations) and bouncing back. Up and down with 20% volatility, stocks will become a trader's dream and an investor's bane. Dividend stocks that trend sideways will become the best solid investments during this short period.
Overall, "raising cash" is not to be avoided. Raising cash can help investors pivot their strategies and adapt them to a new type of market. Eventually, a tipping point will be reached to where the majority of investors accept this fact - that's when people begin regretting not raising cash.
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Disclosure: I am/we are short AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also long IBM via OTM call options.