Buying during a correction is like eating a sandwich. It seems simple. You just eat it. You just buy it. End of discussion. You can stop reading.
Not so fast.
I thought of the "eating a sandwich" metaphor because I happen to be eating a Jimmy John's ham and turkey club as I write this. Eating a sandwich while writing an article is anything but simple. Did you know, by the way, that the Earl of Sandwich invented the sandwich because he needed a way to hold food in one hand in order not to have to stop to eat while he was gambling? He happened to be a pretty good gambler, too, enough so that he finds his way into literature on the subject of risk. You should check him out.
But back to the sandwich. I decided on a sandwich for the same reason as the Earl did - something simple to eat while trying to multi-task in order to get on to all the other stuff I have to do. Eating a sandwich looks simple, but it isn't. You think you just wrap your fingers around it, clutch it to your lower palm and chomp away. What you end up doing is squeezing first the tomatoes and the shredded lettuce and then the ham and turkey and mayo all over your desk and then yourself. The crust doesn't help. Your hands start to get sticky, then your face, and it's worse if you have a beard like me. Somebody should write an instructional manual.
That's exactly how it is about buying corrections. You think it's simple and you know how to do it, but you don't. The minute a correction happens, you realize there are lots of questions and complications you wish you had thought out in advance. You either freeze with your finger on the buy trigger, or you rush to do something in haste and regret it as soon as you hit the button.
There's a solution for this problem, and it's called having a plan. What follows are some thoughts about making a plan. Let's have a look at some of those complications, starting with what we know and what we don't know.
What We Know And What We Don't Know
The one thing we know with certainty is that a correction is coming. What we don't know is when it is coming. It may come in May. It may come in September. It may have started a couple of weeks ago. It may not come until 2018.
Success in predicting the arrival of corrections is pretty much random, which means somebody will have gotten it right after the fact, but who? My view: It gives every market maven her 15 minutes. Remember Elaine Garzarelli, who was spot on calling the 1987 Crash? I had to look her up like an old girlfriend. I couldn't even remember her first name. Google found her from my approximate spelling of "Garzarelli." These days, she's doing a newsletter which I had never heard of. She nailed it in 1987, I have to say.
- So we don't know when the next correction is coming, or whether we are already in it.
Here are some of the other things we don't know:
- We have no idea why the next correction will happen. We certainly have no idea of the proximate cause - maybe a butterfly beating its wings funny in New Zealand.
- We have no idea how big the drawdown will prove to be. This unknown is important, and requires careful attention in making a plan.
- We don't know if the next drawdown will be associated with a recession or with some sort of unexpected shock, or if it will just be a correction in price and valuation. The 1987 Crash did not come with either a shock or a recession. There were investigations, mostly centered on "portfolio insurance," but then-president Reagan probably nailed it in real time, saying "Maybe prices were too high." The similar Crash of 1929 was followed by the worst decade in U.S. economic and market history.
- We do know a few things that don't help as much as we think. We know that 10% corrections happen all the time, about one a year, but corrections of 30% or more happen only once, sometimes twice, per decade.
The trouble is that every 30% correction starts as a 10% correction. When the market reaches a 10% decline, we can't know for sure which we are dealing with.
Accepting the things that we do not know and the limited value of the things we do know is the basic starting point for dealing with a market drawdown. It's the beginning of wisdom.
What we need to work out is some sort of strategy for what we should do when that correction occurs. We need to make a plan. It's better to do that now, before the fact, than later, when there is a tendency to get caught up in the emotions of the moment.
If You Simply Rebalance, You're Fine
If you already have your portfolio set up for automatic rebalancing, you're aces. You have it covered. What this implies is that you have a particular type of portfolio - probably low-cost index funds - which lends itself to simple mechanical rebalancing. Rebalancing means bringing that portfolio back to a set level of stock/bond allocation at regular intervals. It's intentionally random. This saves you from the tendency some human beings have - not you and me, of course - to experience panic or make errors in judgment, but it also stifles your personal genius. You'll do fine. Vanguard will even do it for you. It's the great second best. Sometimes it comes in first.
As for me, I can't use mechanical rebalancing easily, and I suspect many Seeking Alpha members are in my position. For one thing, it's hard for me to sell. Selling has undesirable consequences. The main reason is that I own a highly concentrated portfolio of carefully chosen stocks, many of which I have owned for some time. A large percentage of my portfolio consists of embedded capital gains, and I can just sense the IRS licking its chops to get after me. Partly for that reason, my ideal holding period, like Buffett's, is forever, or at least until my death provides the portfolio with a step-up in cost basis. The only way to reduce my equity side is to let cash mount up as it comes in, the same thing Buffett does. That's the sell side of "Buffett Rebalancing."
What I try to do in my portfolio is buy corrections when it makes sense to do so. Again, I think many SA readers may be in a similar position. That doesn't mean the rebalancing concept doesn't matter to me. It just means there's an asymmetry - I can only buy. It means that I want to buy corrections in such a way as to get the best value for the cash I have to deploy. I don't want to do it mechanically, but I want to incorporate enough of a mechanical element in my decisions that emotions don't have a chance to voice a ruinous opinion. That's what a plan is, whether formalized or not.
I think this approach also has some parallels to Buffett's. Mechanical rebalancing isn't Buffett's approach either. (Other than not doing passive rebalancing, be aware that I am not suggesting any personal comparison to Buffett.) Buffett has a history of reducing his equity exposure radically when he feels the market is too expensive, but because he shares the problem of embedded capital gains (see this article on how that problem looks from his perspective), he sometimes resorts to radical things like buying Gen Re in 1998, partly because its heavy bond exposure served to dilute Berkshire's equity exposure.
I also think his predominant recent purchases of capital-intensive and somewhat cyclical companies - the Kraft-Heinz (NASDAQ:KHC) deal being the exception) - are a way of diluting the importance of positions he can't conveniently sell, such as Coca-Cola (NYSE:KO) and American Express (NYSE:AXP).
Buffett also tends to pile in with a heavy foot when he is able to buy things at what he considers a bargain price. I am less confident in my ability to identify the optimal moment when a particular asset is that kind of screaming bargain. Nevertheless, with less skill and more caution, you and I can develop a plan to do something like that. You could think of it as "Buffett Rebalancing."
Forming A Plan For Deploying Cash In Stages
When the market is down a little, you want to buy a little. When the market is down a lot, you want to buy a lot.
It sounds simple enough. How can one develop a plan that will accomplish that? Please remember that the details of such a plan depend, to a great extent, on individual needs and goals. That being said, you can start with the fact that there are really only two answers about what you should do when the market experiences a drawdown. One is to sit tight and do nothing. The other is to buy.
The assumption here is that you had your equity allocation where it should be to start with. If you kick into sell mode when a correction is underway, you are making an effort after the fact to do something you wish you had done earlier. Selling into a correction almost always turns out to have been wrong. If you have some sort of cash position and were allocated prudently to start with, your policy inclination during a correction should be to buy.
But when? And how much?
The problem in answering these questions always involves the fact that you can't really tell how far a drawdown is going. If you told yourself you would buy a lot with the market down 40%, you might go to the end of your days waiting for the opportunity. If you went all-in with a correction of 10-20%, you might have to watch in horror as the market continued to fall another 20-30%. That happened to many investors in the 2000-2003 and 2008-2009 debacles. You can never be sure where a correction will stop.
A good first step is to write down on a sheet of paper the total amount of cash you have to deploy - your "all-in" number. The next step - the big one - is to determine the process by which you will deploy it. One easy way is to divide your cash into four or five equal amounts and match them up with four or five levels of market drawdown. You can design your own buying stairsteps, but here's an example of how one might look:
- Market down 10%: Use 20% of available cash.
- Market down 20%: Use another 20%.
- Market down 30%: Use another 20%.
- Market down 40%: Use another 20%.
- Market down 50%: Use the final 20% and go "all-in."
Voila! You have a simple structure and don't have to ask yourself the "How much now?" question on a daily basis. If the market turns around and heads back up after a smaller drawdown, you just stop and wait for the next correction. Wash, rinse, repeat.
If you happen to think the market is stretched well over fair value, as I do, you may want to try a little harder to commit a lot more when the market is down a lot more. Here's an outline of a strategy for doing that.
The Martingale Strategy and "Buffett Rebalancing"
If you want to make a stronger effort to buy a lot when the market is really, really cheap, there's a different design for the stairsteps. It has a certain resemblance to the gambling strategy called Martingale, in which the bettor doubles the bet each time he loses. Martingale is a form of doubling down which is disastrous if you are a gambler. The Earl of Sandwich surely knew that, and by the way, I can mention here that eating a sandwich while typing gets worse as the sandwich gets smaller. A modified and more modest Martingale approach can serve your purpose as an investor without the gambler's risk of ruin.
If you invest heavily in the early stages of a market decline, you have lost the bet, in a way. This can be avoided if you reserve enough cash to double down at the next level down, if the market continues to fall. That's more or less what Buffett has done over the long term. He continuously puts money into stock purchases and acquisitions - more regularly now than he used to - but he still tries to go in much bigger when the market is down heavily. Recall his deals of 2008-2010. His frequent quote on his frame of mind at moments like this is that he feels like an oversexed man in a harem.
Here's an outline for a buying program which increases the amount invested at each successive level.
- Market down 10% or less: I generally sit tight. My reason is that in almost every instance, I will have owned basically the same portfolio when the market was 10% lower. If I was satisfied with my stock allocation at that time, it would be the same after a 10% correction. I would have no reason to change it. On occasion, I have bought a small position in one or two stocks which suddenly looked cheap. I bought a couple of things in moderate size in February 2016 - Chubb (NYSE:CB) and United Technologies (NYSE:UTX), to be specific. So far so good.
- Market down 20%: Use 20% of your cash reserve. Statistically, a 20% decline is about what you get on a regular basis.
- Market down 30%: Use an additional 25% of your original cash amount. At this point, you will have deployed 45% of original cash available, over half of it near the bottom of a significant correction.
- Market down around 40%: Use an additional 30% of your original cash. At this point, you will have deployed 75% of original cash available, 40% of it at the low point of a major down move.
- Market down 50%: Use the last 25% of your original cash position and go "all-in - 100% invested." This won't happen very often. If the market continues to decline, turn off the TV and stop looking at brokerage statements. Tell yourself that you will look brilliant in the long run. If you're nervous, buy canned goods and set up a cot in your basement.
You could adjust these numbers as you wish - both the levels for drawdowns and the amount of cash you plan to commit. Starting with a lower initial amount and using a steeper rate of increase might produce a home run, but you have to remember that many corrections stop around 20% or so, and that may be the best chance you get.
What To Buy
This may be the most important question of all. There are several ways to look at it, and I will try to cover a few of the major ones:
- Simply buy more of what you have. This is easy for an indexer or other well-diversified investor, but would be very wrong for me. My portfolio is highly concentrated, and an advisor who put an investor as heavily into Berkshire Hathaway (BRK.A, BRK.B) as I already am would probably get sued. As much as I love it, I can't buy more.
- Buy exactly what you don't have, in order to diversify. This is a strategy I have been thinking about because it is the only good way to diversify away from a high level of concentration. That was the "Buffett Rebalancing" trick when he bought Gen Re for its bond portfolio. I would need some areas of the market I don't already own to start looking better and cheaper for me to make this my primary goal.
- Buy things you have wanted to buy at the right price. For some time, I have watched Alphabet (NASDAQ:GOOG) as its valuation crept down toward the range of moderately high-growth companies. If it hit my target in a correction, it would serve nicely to diversify my low-P/E financials, industrials, and cyclicals. Apple (NASDAQ:AAPL) has recently gotten onto my radar too, possibly the Buffett halo. I never quite copycat Buffett, but his imprimatur sometimes tilts my opinion a bit.
- With the market down 40-50%, I would look carefully at index funds. They currently don't work for me because cap-weighted indexes are more concentrated in high-flyers than I am comfortable with, but if a correction squeezed market P/Es toward the center - reduced dispersion, as they say - I would look at an S&P index vehicle (NYSEARCA:SPY) and maybe a value or small-cap index fund.
- If stocks drop, along with a massacre in bonds, because rates are up sharply, you might compare stocks to longer-duration bonds and possibly tilt toward bonds. I thought I would never say those words, but hey, I'll be 73 this year and own no bonds at all - zero - so at the right price, maybe.
"Buffett Rebalancing" And The "Buffett Dilemma"
The idea of "Buffett Rebalancing" may have Buffett all wrong. He certainly did very radical shifts in his early years, getting out of stocks by returning the money in his partnership in 1969, and getting back in with a heavy foot in 1974 around the time he wrote his famous Forbes article, "Look At All Those Beautiful, Scantily Clad Girls Out There." I think by "girls" he must have meant stocks. His most recent major rebalance away from stocks was the Gen Re deal - the "Buffett Rebalance" of the title - when he leaned one way (toward bonds) to have an effect in another (diluting his portfolio of stocks). It's possible now that he just takes large deals whenever they come along.
I have also thought that in the recent zero-return environment for cash, he has sometimes looked at a deal's cash flow versus zero return on tens of billions and said to himself, "Oh well, the company throws off cash and will never trade again, and by the time interest rates change it will have thrown off a ton of cash." It's one solution to the problem of cash coming in regularly with no safe return across the broad spectrum of assets. It was the solution to what you could call "the Buffett dilemma." So maybe he has moved away from the goal of waiting to pounce on deep corrections. Maybe he felt forced to.
There may be some hints in what he said on CNBC the Monday morning after his recent annual letter:
Buffett: Well... I've been talking this way for quite a while, ever since the fall of 2008. I was a little early on that actually. But I don't think you could time it. And we are not in a bubble territory or anything of the sort. Now, if interest rates were 7 or 8 percent, then these prices would look exceptionally high. But you have to measure, you know, you measure everything against - interest rates, basically, and interest rates act like gravity on valuation. So when interest rates were 15 percent in 1982 they'd pull down the value of any asset. So, what's the sense of buying a farm on a 4 percent yield basis if you can get 15 percent in governments? But measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is, is that - that interest rates go up a lot, and that brings stocks down. But I would say this, if the ten-year stays at 230, and they would stay there for ten years, you would regret very much not having bought stocks now.
The idea for this article came from a comment to an earlier article, which expressed curiosity about just how I planned to deploy cash in a future correction (and which, for the life of me, I can no longer find). It is also influenced by a problem I am trying to solve in getting an elderly aunt set up in an index-fund portfolio, which will probably pass in its entirety to children just a little younger than me (thus looking ahead to retirement) and who are quite conservative. The problem is how to phase in, over time, in a market that seems high, especially for index fund investments.
I thought I knew the answer about buying corrections in general terms, but thinking carefully about it has probably provided more questions than answers. It was useful to try to think it through more systematically. I learned a few things along the way and formalized my thinking about a few things. This is one of the great purposes for writing and reading articles on Seeking Alpha. This article is not a definitive solution, and I would like to hear alternative thinking.
Thanks to that commenter, and thanks to you for reading. As you see, I pay attention to comments and try to respond. With this article, I may be a little slow in response because I am going on vacation, and my laptop, when not slaved to a screen with a mouse, has a critical key that sticks. You can guess why. I will ultimately respond.
Disclosure: I am/we are long BRK.B, CB, UTX.
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.