Tracking How Far They Fell: March Edition

Summary

• In January, I began publishing articles that examined how far several large-cap industrial stocks might fall during a bear market, and I suggested some alternative investments.
• This article will examine how those industrial stocks are tracking against the more defensive alternative investment ideas.
• The most recent mini-correction in March, driven largely by politics and government policy, produced some interesting market moves.
• Defense stocks continued to hold up well, but Aerospace joined Dividend Growth stocks' underperformance, and Deep Cyclicals continued to get hit hard.
• Overall, of the 11 industrial stocks I wrote about in January and February, 9 of them underperformed my suggested alternatives. I offer my views going forward into 2018 about the prospects of both.

Introduction

In mid-January, I began writing a series of articles that examined how far some popular large-cap industrial stocks might fall if we were to have a downturn within the next three years. I continued writing about stocks in the industrial sector through the month of February, eventually covering a total of 11 popular large-cap industrial stocks: Caterpillar (CAT), Boeing (BA), Cummins (CMI), Deere (DE), General Dynamics (GD), Northrop Grumman (NOC), Eaton (ETN), Emerson Electric (EMR), United Technologies (UTX), 3M (MMM), and Rockwell Automation (ROK).

While all the articles were generally bearish in nature and meant to be a warning to current investors that even the stocks of good companies could fall quite far during a bear market, I didn't stop there. In each article, I suggested alternative investment ideas for the stocks in question. With the exception of 3M, whose suggested alternative investment was Johnson & Johnson (JNJ), those alternative investments either took the form of the PowerShares S&P 500 Low-Volatility ETF (SPLV) or the Vanguard Utilities ETF (VPU), or a split between the two.

This article will examine how those alternatives are performing so far, and I'll also relay some of my observations about the market, as well as some general takeaways or investing lessons we might learn from tracking these results. I am a big proponent of reviewing and tracking performance because we can learn so much from it. I know for certain that I've learned a lot from carefully and painstakingly analyzing both my mistakes and my winners over the years.

Overall, the alternative investment ideas are performing extremely well so far against the original industrial stocks. 9 out of the 11 alternatives are outperforming the target stocks, and most of them are significantly outperforming. Now let's take a closer look at each individual investment, and I'll also comment on some general takeaways and lessons I've learned so far.

Takeaway #1: Deep cyclicals are behaving as expected

One of my observations in February's article was that deep cyclical stocks were performing very much how I expected, and they had dropped significantly compared to the alternatives during our first mini-correction in February. That behavior continued as expected in March and was perhaps enhanced by President Trump's tariff announcements. All of the charts will start from the day of publication of the article for the stock in question.

First, let's look at Caterpillar and Cummins:

CAT Total Return Price data by YCharts

CMI Total Return Price data by YCharts

Caterpillar and Cummins were two of the earliest cyclicals I wrote about in mid-January. Despite having pretty good earnings reports, these stocks both got crushed during the mini-correction and haven't really recovered at all. This has to do with the fact that they were both near the top of the economic cycle and they were both overvalued. The stocks could still rebound, but if they do, I would certainly be a seller into the strength because if we have an actual recession, these stocks will fall much farther than they have already.

Takeaway #2: Defense stocks might be the last to fall

During the February check-up, Aerospace and Defense were holding up very well even after the mini-correction, and they were outperforming my alternative ideas by a small margin. One month later, this is still partially true, but now only the stocks that are primarily related to Defense outperformed the alternatives. Here is a look at Northrop Grumman and General Dynamics, the only two stocks that have outperformed the alternative ideas the past two months:

NOC Total Return Price data by YCharts

GD Total Return Price data by YCharts

Northrop has outperformed the alternative ideas by a couple percentage points, and General Dynamics narrowly outperformed both alternatives as well. In February's check-up, I commented on Trump's expected defense spending and how as we approached the fall election, where Democrats seem increasingly likely to take over the House of Representatives, that I thought defense stocks might be vulnerable the closer we got to the election. Since then, Congress passed and approved a spending bill with increased defense spending. Now that that bill has been passed, I think that, outside of a full-scale military conflict, all the good news over the medium-term is probably priced into defense stocks at this point. Even since the passage of the spending bill, I've noticed these defense names have weakened relative to the alternatives I suggested. I wouldn't be surprised to see these stocks slowly begin to underperform the alternatives the closer we get to the election provided there isn't a significant military conflict between now and then.

Takeaway#3: SPLV is doing its job

Back in February, I had a little side-debate with another SA contributor about my low-volatility strategy, and SPLV in particular as an alternative to SPY, since SPLV had been one of my primary alternative investment ideas. His thesis was that SPLV had underperformed YTD through the February mini-correction and so he thought SPY was a better investment. I disagreed and pointed out that SPLV hadn't rebalanced yet, and that when it did, it would become "smarter." SPLV did rebalance at the end of February, and so I wanted to take a look at how it performed against SPY during the month of March after the rebalance since we had another correction. If my thesis was correct, SPLV should have performed a little better than SPY:

SPY data by YCharts

This chart starts on March 1st after the SPLV rebalance, and as we can see, SPLV is working exactly how it is supposed to. That 3.5% spread might not look like much, but it is significant outperformance for only one month, and most importantly, SPLV is outperforming when the market drops, which is what we want to see. Here is a longer-term chart from when I first recommended SPLV as a good alternative investment in January:

SPLV Total Return Price data by YCharts

I'll probably write a full article on this in the near future.

Takeaway#4: We don't have to precisely predict triggers

When stocks are overvalued or undervalued, we don't have to predict the catalysts that will bring the price back closer to fair value. I learned this from Howard Marks in his book The Most Important Thing. Toward the end of the book, he noted that when he buys things at a good value, he doesn't try to predict what will bring the price up. I think the same thing applies in reverse to overvalued stocks like Boeing. I didn't have to predict that Trump's tariff threats would bring the price down. It just as easily could have been any number of other issues that triggered the sell-off. When a stock is overvalued, it is vulnerable to any narrative that gains widespread attention. This time around it just happened to be tariffs.

BA Total Return Price data by YCharts

The same goes for every other stock I wrote about in January and February that was overvalued. These charts are all from the publication date of my articles. The blue stocks are the ones I suggested investors should rotate out of:

MMM Total Return Price data by YCharts

ETN Total Return Price data by YCharts

ROK Total Return Price data by YCharts

UTX Total Return Price data by YCharts

The main thing to note here is that the alternative investments are doing what they are supposed to be doing and falling less than the target stocks. I didn't know ahead of time when I started writing these articles back in January that the market was going to correct, so I just got lucky I guess that the market started getting jittery. The more difficult challenge that I think I did a pretty good job of solving was identifying good alternative investments for when the market did eventually fall.

Takeaway#5: Rotation eliminates market-timing problems

When one looks closely at the dates of publication of my articles over this time period, they should pay close attention to the fact that what the market was doing that particular day or week had no bearing on what I was writing about. For example, I wrote about Emerson Electric on February 7th, one day before the market hit the bottom of the mini-correction. Here is how it has performed since:

EMR Total Return Price data by YCharts

Conversely, I wrote about Deere on January 24th, just two days before the 2018 peak of the market and suggested VPU as the alternative. Here is the relative performance of those two:

DE Total Return Price data by YCharts

My point here is that investors who claim that what I'm doing is "timing the market" don't have a very strong case. While I certainly take into consideration where we are in the economic cycle (as best I can), none of these defensive alternatives would have taken an investor "out of the market". They would have simply rotated investors out of overvalued stocks into investments that are 1) more fairly valued 2) more defensive and likely to fall less during a downcycle, and 3) more diversified. I would also add that no matter how one goes about defining risk (whether it is volatility based, the likelihood of permanent loss of capital based or measured as concentration risk), the alternative investments were less risky on all accounts.

That doesn't mean there is no relative risk to the alternative investments. The main risk is opportunity cost risk if the target stocks have another several years of rapid growth in the future, and do not have a drop in price far enough to entice us to rotate out of our defensive positions and back into the target stocks. So there is risk associated with the alternative positions, and it does take some skill in order to recognize when the relative valuations are good enough to rotate back into them (and have confidence enough to have the courage to do so). But again, this will ultimately be determined by the valuation and business prospects of the target stocks, not the overall market.

Bonus

I'm always still looking for stocks to buy, even when the market is high. Owens & Minor (OMI) looked very enticing back in February, but upon closer examination, I thought Hawkins (HWKN) was a safer alternative, so I wrote an article about them. I thought I would include how that investment idea is performing:

OMI Total Return Price data by YCharts

This was a situation where even though Hawkins wasn't trading at value levels, it was trading at fair value with a solid business, while OMI's business was questionable.

Conclusion

On average, the 11 industrial cyclicals I wrote about in January and February returned -5.3% while the alternatives returned +0.41% through the end of March. In March, I began examining stocks in the service sector and how far they might fall during a downturn. At the end of April, the stocks from March will be included in this update as well. Those new stocks will include Union Pacific (UNP), Costco (COST), CSX (CSX), S&P Global (SPGI), and FedEx (FDX). It should be an interesting analysis because for these stocks, as my alternative, I recommended Berkshire Hathaway (BRK.A) (BRK.B). Berkshire's dynamics are a little different from VPU and SPLV in that during a downturn, I expect Berkshire to fall about the same as the market for the first 15% of the decline, but then I expect it to begin falling less than the target stocks. I haven't checked to see how it is doing compared to the target stocks so far, but I doubt that unless we have another 10-15% drop in the market, that Berkshire will distinguish itself the way SPLV and VPU did in February and March. Time will tell.

Also, I plan to focus more heavily on "How far could they fall?" service sector articles in April. In March, I diverged a little more than I would have liked to with articles about medium-term investing, advice for millennial investors, defending my low-volatility strategy, pointing out some dangers for Thor Industries (THO) over the medium-term, and a comparative analysis of Target (TGT) and TJX (TJX). Those were all worthy topics, and either necessary or timely, but I only ended up writing five pure "How far could they fall?" articles. While I do plan to write a follow-up to my Charitable Investing article, and an article on tax strategy in April, I would really like to double my output of "How far could they fall?" articles from March. So, you might see a little more straightforward analysis from me in April and a little less creativity and strategy, but I promise to sprinkle a couple "think pieces" in every fourth or fifth article or so.

Final note: My followership has grown about 200% during the first quarter of 2018, and I want to thank everyone for their support. The comments and feedback have been very helpful in my continuing effort to become a better investor and a better writer. Thank you all very much.

Analyst’s Disclosure: I am/we are long HWKN, 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.