How To Ride The Waves Instead Of Getting Trampled By The Herd

Includes: GE, IDTI, NASDX, SPY
by: Esekla


Some notes on what to look at and what to ignore.

Plus a history lesson illustrating what to be afraid of and where to seek safety.

Finally, a warning about current market composition.

Investing in modern markets is an exercise in mixed metaphors. The bull market is long in the tooth, yet the economy is supposedly stronger than ever. Behind such conflicting messages lies an investment industry that must resort to trading volatility, even if that means creating it. As we move to close out an October where the Nasdaq has dropped almost 13%, and the S&P 500 10%, some subscribers are asking if another 2008-style crisis is imminent and if they should be selling everything.

Some Notes on Signals and A Recap

Many analysts look at higher treasury rates as negative for stocks, and while I acknowledge the correlation, I think treasuries offer little predictive value. By the time rates move higher, the damage to stocks will already be well underway, as we've just seen. Instead, my experience leads me to look at a very different set of data points, including currencies, macro news, and arbitrage spreads. Here's a recap of what I've written in the macro section of my website over the last month:

  1. Most recently, that risk is slightly elevated, as measured by the 7% buyout spread on Integrated Device Technology (IDTI), which I've covered from the teens on up to the current price in the high forties. Over the past two weeks, that risk measure has increased by about a percentage point even as IDT continues innovating. My comments on the significance of the Japan-China relationship are more relevant than ever, and probably account for most of the change. Today's M&A environment is certainly different than it was for InvenSense, and I still don't find this arbitrage compelling yet.
  2. As the drop started on October 4th & 5th, I wrote that the jobs report was negative for stocks, and that further distraction and volatility were likely, but that I don't think this is the beginning of a sustained (multi-month or year) downturn.
  3. Perhaps most importantly, with a week left in September, before the drop started, I wrote that it was a good time to build up some dry powder and that the market had become accustomed to a bounce back from every dip, which was an increasingly dangerous assumption.

Basic Strategy - Ask the Right Questions

So, to answer the specific question... do I think there is a need to sell most stocks and hold cash? No, any statements on macro timing are guesses, but cash is certainly a hidden tax, unless we are in a deflationary environment, which I don't think is the case. To me investing is not a question of whether or not the market will bounce back, it is two easier questions:

  1. Will I need the capital for something else?
  2. Will I earn more from dividends and/or growth than I would lose from a market drop?

My answers are No, and Yes - over the long term. As I've said for the past few months, though, my answer might change somewhat once I see the reaction to the mid-terms. So, could we be in the lead-up to a drop similar to 2008? Yes, that's possible, though still less likely than not, and frankly, the mere possibility still doesn't cause me to consider going anywhere near 100% cash because, again, I accept that I cannot time the market exactly, and don't need to.

A History Lesson

2008 chart

To put some color on that, the market hit a then-high in November of 2007 but was only 12% lower by June of 2008, even though the danger signs had been around for quite a while. That's an average drop of 1.5% per month or 18% annualized. The bottom really fell out in September and October of 2008, when markets lost about 40% in two months. That would be about 240% annualized, but it should be obvious that figure is irrelevant as one can't lose more than 100%, at least if one avoids leverage, which is a principle I've always espoused. Those who bought or held for the 4 months between then and the beginning of 2009 have made over 400% or 40% per year in the years since, based only on index value and ignoring dividends. The lesson here is that, so long as I don't have to sell, I am more concerned with the length of downturns than their severity.

So, the real question to ask is not about a reprise of 2008, it is about 2000, when the Nasdaq lost well over two-thirds of its value in a sustained drop that lasted more than two and a half years.

markets 2000 through 2002

However, the S&P lost less than 50% over that period, or about 20% annualized. This may be the only time you'll ever see me mention the DJIA, because I am of the opinion that it has become outdated and irrelevant, but it lost just over a quarter of its value, or 11% annualized. I mention it now, because back then it really was made up of comparatively higher quality dividend stocks. If you look at the yield on CenturyLink (NYSE:CTL), and other stocks where my analysis is not public, they would pretty much make up for the temporary paper losses in the Dow, and the wait could be regarded as the price of buying in at the exact bottom to make the profits that I talked about in the prior paragraph. Those returns can be enhanced by an understanding of macro trends like the shift in energy and finance markets that I've been writing about for a year or more now, and inclusion of stocks that actually benefit from market turbulence.

A Final Warning and Conclusion

In the meantime, hopefully this discussion explains why I often raise some capital for new opportunities but am almost never tempted to sell most of my holdings, which are primarily high yield and high quality. Today's market has many investments that are every bit as stupid and risky as those in the Nasdaq circa 2000. Furthermore, quality has become harder to discern. For instance, I tried to warn people about General Electric (GE) almost three years ago. It has lost over two-thirds of its value and cut its dividend from 23 cents to a penny. By contrast, the alternative I suggested in the follow-up article back in March has risen 40% since then, and increased its dividend since I began private coverage.

My opinion is that the market is FULL of stocks like GE. There will come a time when the passive investors relying on questionable news, money managers and index funds which make up most of the market's capital these days get killed. The recent tantrum exacerbated by Amazon (AMZN) and Alphabet/Google (GOOG) (NASDAQ:GOOGL) looks like a harbinger of that. It may be that investors will learn and that we are seeing the beginnings of a rotation toward the high yield defensive names that I've been espousing all along, which could generate profits in the names I've selected even if indexes continue declining. That's why I've actually been investing recently freed capital over the past few weeks. No matter what happens, investors relying on valuation and accurate fundamental analysis of individual companies should be able weather even the worst downturns relatively well and come out shining in the long run.

Disclosure: I am/we are long AES.

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.