Seeking Alpha

The Powerful Arithmetic Of Deploying Cash When The Market Is Down A Lot

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Includes: BRK.A, BRK.B
by: Jim Sloan
Jim Sloan
Long only, value, growth at reasonable price
Summary

The arithmetic of buying when the market is down hard is powerful; a 50% decline requires a 100% advance to break even. Investing near the bottom is very powerful.

In this article, I present a couple of possible guidelines for investing at intervals during market declines. Any reasonable plan calms the nerves and helps avoid mistakes.

Buying 25% at four intervals is a simple program for modest advantage. Buying more at deeper levels of decline may greatly improve results in a major decline.

If you are a good picker of stocks or sectors and invest long term, you may wish to keep the intervals fuzzy and buy when something you really like gets cheap.

That said, I don't usually buy 10% declines and caution about piling into this one with both feet unless you wish you had been more heavily in stocks two or three months ago.

This is the third in a series of three pieces having to do with your cash reserve. The first noted that with rates rising, active management of your cash mattered again. The second argued that cash reserves are the only really effective means for hedging against losses (and having peace of mind) in a market correction.

This article deals with what cash can do for you when you invest during a correction or a bear market. The powerful arithmetic of committing your cash reserve when the market takes a tumble calls for a strategy to maximize your chance of doing so, and this article will discuss some potential strategies.

The biggest challenge to a strategy for buying corrections is that you want to buy most heavily when the market is down hard, but you also want an intermediate level for committing some cash earlier so that you don't miss the chance entirely if the market turns around and heads back up. My definition of cash reserve, by the way, is that it is money which might be invested in equities - is part of your equity bucket, so to speak - but is held in cash or near cash as a strategic defense while waiting for a better moment to invest.

The power of having a cash reserve to invest during market declines derives from very basic arithmetic. In percentage terms, a market decline does more to harm you than the same percentage gain does to help you. That's not opinion. It's simple arithmetic. This may seem a bit counter-intuitive if you are not on friendly terms with numbers. Let's say a market declines 50% from the price of 1,000. That leaves the market price at 500. To get back to 1,000 requires an advance of 100%, not 50%.

Nothing about this is news in the world of financial advice. This simple bit of arithmetic is frequently cited in financial literature as a word of caution to try to avoid dramatic losses. It is also sometimes cited in discussions of mutual fund results as reported. If a fund is down 50% in one year and up 100% in the next, its average annual return is a misleading 25%. The reality is that if you held on for the complete round trip, you are back exactly where you started. After the two years, your return as a holder of the fund is exactly zero. All of this is useful to know when looking at fund numbers - and at your own annual performance numbers, for that matter.

But let's see what happens when you are holding a cash reserve which you can put to work in a market decline. Let's for the sake of a very clear example posit a cash reserve of 30%. This is a very substantial percentage of cash to hold in an equity-committed portfolio, but it's not uncommon. It is in fact the percentage my 48-year-old son presently holds. At 73, I actually hold quite a bit more, but my age makes me a bit more conservative and determined to hold on to what I have. Both of us, I should mention, would prefer to be close to 100% invested, and would hope to get there when the market is significantly undervalued.

By all historical criteria, the market is not currently undervalued. It appears by many criteria to be significantly overvalued. I was struck by the headline and content of this recent post by Doug Short, a fact-oriented and generally understated SA writer. Doug's posts are more those of a meticulous bookkeeper and historian than of a provider of market opinions, but he is straightforward about what the valuation numbers imply.

Just for the sake of demonstration, let's posit the event of a 50% market decline, which is an uncommon, virtually generational event (although it has happened twice in the past two decades). Let's then also posit a much less likely event - that an investor might actually have perfect timing putting his cash reserve back into the market - the whole 30%. Even if a 50% market break happens, I won't be able to do that, and most of you readers won't either, but it makes for a very clear illustration of the way the arithmetic works.

Begin with the fact that the investor who is 100% in stocks is down 50% at the bottom and has to wait for the market to rally back 100% to reach the breakeven point. The investor with a 30% cash reserve, however, will be down only 35% at the bottom, half of the 70% in stocks. That leaves 35% of initial capital in the stock side of the portfolio plus 30% in the cash side - a total of 65% of the starting position. Thus the drawdown is only 35%.

Now let's posit an improbable bit of timing: The investor puts all 30% back into the market at the bottom. At this point, it may be clearer if we change percentages into "units" - as if each investable percentage at the start equaled one unit. With the market selling at half price, the investor is able to buy 60 units instead of 30. The total number of units is then 70 (the initial stock position) plus 60 (bought at the bottom), a total of 130. The average cost per unit is roughly .77 compared to the 1 unit paid by the investor who bought 100 units (100%) initially. As a result the investor with a 30% cash reserve only needs the market to advance from 50 to 77, about 54%, in order to be back at breakeven. By the time the market gets back to its old high, the investor with the reinvested cash reserve is up about 30%.

You may have noticed that this is just a more extreme example of the advantage of dollar cost averaging or regular dividend reinvestment, in both of which you put more money into the market when prices are lower. Can an investor actually employ a cash reserve in market declines to achieve a more powerful effect of cost averaging?

I'm sure you are thinking that nobody ever nails the exact bottom. You are exactly right about that. Most get back in earlier or fail to get back in at all. You won't have that level of perfection in timing, but you can do pretty well if you have one thing in place: a plan.

In this article written in March of 2017, I wrote about the options for deploying a cash reserve and suggested two ways of doing it. I strongly suggest you read or reread that article if you have been thinking about strategies for committing your cash reserve. The short version included two ways of putting together a plan for investing during a decline - the simple version and a more complex version attempting to buy heavily near the low of a major bear market. Both attempt to address the fact that corrections and minor bear markets may happen more than once before a major bear.

At this moment - which may be a mere blip or the beginning of a major decline - I am going to explain the plan I have right now for getting back into a more fully invested position. It hinges on one opinion but otherwise is simply arithmetic.

The opinion is this: whatever triggered the recent declines - the VIX implosion, the increase in the rate of the 10-Year Treasury, or something else - the underlying case is that market valuation is abnormally high, maybe by a modest amount, maybe by a lot. Reasonable and well informed people can argue about the degree. Whether the degree of overvaluation is moderate or deep, a highly valued market is vulnerable to declines that start in peculiar and seemingly trivial places.

Plan One: Investing Equal Percentages At Intervals

Small corrections (5 or 10%) happen frequently, and I generally think it is not worth taking action. If I was content with my allocation when the market was 10% lower, then I have no reason to raise it after a 10% decline. It is harder to ignore a decline that meets the criterion for a cyclical bear market (20% to 30%) or thereabouts, and I often do some buying around that area. Declines in the area of 40-50% are quite rare indeed, even though many readers are old enough to have experienced two of them. Most readers will live to experience one or two cyclical bears (20-30%), perhaps one within the next year or two, and with market valuations quite high, one can't rule out one more major bear within five or ten years.

A good plan has to address these facts, letting you invest part of your reserve during small declines while leaving cash to use if a decline continues to the next threshold. Having that in mind, I proposed the following simple and straightforward program in my earlier article.

  1. Market down 20%: Use 25% of available cash.
  2. Market down 30%: Use another 25%.
  3. Market down 40%: Use another 25%.
  4. Market down 50%: Use the final 25% and go "all-in."

What are the results of doing this? If the correction stops around 20%, you will have reduced the average cost of your holdings by 2.4%. When the market completes the round trip to the former top, instead of being back to your original value, your portfolio will be 2.5% higher. Not enormous, but you will have enjoyed the peace of mind that comes with having a plan and knowing that you are highly likely to come out ahead after a rocky time.

What if the market goes down the full 50%? You will have dropped the average cost in your portfolio by about 15%. When the market completes the round trip to the prior high, you will be up about 17.6% from your original value. Plus any dividends, of course. Do the arithmetic yourself.

Nota bene: In the United States the market has always returned to the former high following a bear market of whatever size, and ultimately surpassed it. Past performance does not guarantee future results, as the fund disclaimers say, but it helps in formulating a plan.

The return to this way of averaging is modest. That's fine. The good thing about it is that you have a plan and it is mechanical, so it may calm your nerves and get you to take the right action in a crisis - and probably more important, help you avoid taking the wrong action. It's hard to beat serenity during a long decline. If you don't want to make your life this complex, note also that it amounts to pretty nearly the same thing as a simple re-balancing between stocks and cash, which also works pretty well.

That being said, I believe there is a better approach for the more aggressive investor.

Plan Two: Which I Call "Buffett Re-balancing"

A more aggressive approach to buying heavily near market bottoms is what I called "Buffett Re-balancing" in the article cited above. Here's how I put this in March 2017:

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 50% 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.

I'll let you run the math on this one. You can massage the numbers as you see fit. What I will say is that it bears some resemblance to my own plan - the plan I carry in my head and which is a little fuzzy around the edges.

Not Rules - Maybe More In The Nature Of Guidelines

There is a funny moment in one of those Johnny Depp Pirates of the Caribbean movies when the villain explains to the heroine that in the world of pirates "the code is more what you'd call guidelines than actual rules." I like rules like that and tend to follow many rules in that way - especially in investing. There are a few reasons.

For one thing the market isn't as evenly constructed as the schematic deployments assume. If completely invested in a small number of mutual funds or ETFs it might be. I think most investors on SA are like me, however, and hold individual stocks. Individual stocks don't all become cheap or expensive at the same time.

What I actually tend to do is buy stocks or sectors when they get cheap enough to qualify as a long-term holding. In the above example I had been wanting to buy United Technologies and Chubb and jumped on the opportunity in 2016 with the market down a little less than the 20% hurdle. I think this has been pretty much what Buffett does. It tends to involve a slightly fuzzy interpretation of the rules - more what you'd call "guidelines".

Speaking of Buffett, if you want a stock you might think about that way, consider Berkshire Hathaway (BRK.A) (BRK.B). Last week it got as low as about $190 for the B shares before rallying. By pure arithmetic a decline of five points or less below that $190 would probably take it down to 130% of book value, thanks to some pure arithmetic of the new tax law (reduced liability for embedded capital gains). Because Buffett will buy back shares at 120% of book, 130% of book provides very positive asymmetry between limited downside risk and upside potential. I can't buy it because I have too much already, but you could take a glance at it if the market suffers another whack. You need to understand Berkshire, of course.

One of my personal guidelines is that I generally resist buying at levels where I most recently bought unless something has changed - possibly just the passage of time during which overall value has increased. Another possible change might be the one-time but probably more or less permanent bump up in corporate earnings because of the lower corporate tax rate. The "more or less" has to do with waiting a bit to see the actual result, and also with the possibility that upcoming elections may lead to a reversal of the tax change in the intermediate term.

The last time I bought anything - two home builders - was in January of 2017 when the S&P was 21% lower than at the recent peak. I bought because the sector was cheap, and I didn't see any obvious problem with their prospects.

For the present moment, even with the prospect of corporate earnings taking a one-time permanent jump, I allowed my no-action-at-10% guideline to stand; I am also influenced by the fact that the last time I bought in size, those buys in 2016, the market was 30% lower than it was at the recent high. Because two years have passed and the tax change has occurred, I would have a serious look at a market down 20-30%.

Because I believe the market is pretty expensive, if more or less normal conditions return to the returns offered by fixed income, I want to be sure I have enough cash to take full advantage if the market returns to more historically normal valuation and, as it often does, overshoots to the downside.

The biggest caveat is that this may never happen or will occur so far in the future that the major regret would be not having been fully invested in the interim. If this correction gets close to 20%, I will look closely at things I have wanted to buy at specific prices. Others should carefully sort out their feelings about the trade-off between missing opportunities and having the cash to buy heavily after large downdrafts.

The great alternative is to be fully invested one way or another at all times. That's the view of pension funds and many other institutions as well as insurance companies which must defease known future costs. Over the long term, it isn't a bad second best. Buffett seems to be using this approach for his wife's future needs through the vehicle of an S&P index fund. One could do worse.

A Final Cautionary Note

If you really love something at today's price, even if rates are headed up, you should buy it. I get an uncomfortable feeling, however, when I read comments saying, "Hooray, I bought the dip." It may well work out, but you should bear in mind that at worst, so far, it was a little over 10%. That's nothing in the larger scheme of things. That's where we were in late November/early December of last year. Were you piling into the market for all you were worth then?

Disclosure: I am/we are long CB, UTX, BRK.B. 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.