Slightly less than a year ago, in January of 2018, on the heels of a massive tax reform bill being signed into law, the stock market bolted to new all-time highs. Yet, almost everywhere I looked in the market, particularly among more cyclical stocks, I saw danger. It wasn't that most of the businesses I looked at were bad. In fact, usually, the opposite was true. Usually, what I saw were good businesses whose stocks were trading as if the market or the economy would never turn lower. The prices of cyclical stocks, in particular, were too high, and I was genuinely worried for many retail investors who had no idea of the sort of severe downside they might suffer if the cycle turned down.
I wanted to warn investors about this situation, but I also wanted to do more than that. There are always permabear writers and short-sellers who are willing to share the bear case with investors. My problem with the permabears is that they are like stopped clocks. Eventually, their downside predictions of doom and gloom come true, but not before the market has risen more than enough to compensate for the future downturn on the upside. Just look at the total return of gold (GLD) versus the S&P 500 (SPY) for the past five years. (And this is even after the S&P had a bear market):
The other option that shareholders of overvalued stocks have, is, well, options. And there are lots of great writers on SA that can provide ways to protect your portfolio to one degree or another using options. But, options do have time constraints, and not everyone has an account that is big enough to make using options practical. Others simply want an easier and simpler strategy.
Going to cash is always a potential choice as well. But, timing the top of a stock is notoriously difficult to do. I wanted to find an alternative strategy that didn't require precision. I wanted investments that would beat cash if the market continued to rise, but would fall less than the cyclical stocks during a decline. If I could do that, then I figured if I even got close (within 3 years of a bear market), the investments would outperform.
So, that was my challenge back in January of 2018. I wanted to (1) warn investors that even the stocks of high-quality companies were in danger of deep drawdowns, and (2) provide a simple, long-only strategy that could beat both a buy-and-hold strategy and the S&P 500 over the medium-term (typically 5 years), and (3) perform better than cash if the market rose for another three years without a bear market.
I also wanted to track the results, because all-to-often, when a writer makes a bad call, they tend to disappear, never to be heard from on the topic again. For better or worse, I wanted to track the results and make adjustments along the way for any mistakes I made with the goal of refining the strategy into something useful for retail or long-only investors.
The strategy I came up with was deceptively simple. When the stock of a quality cyclical company with good long-term prospects rose too high, an investor could simply rotate out of that stock and into a more defensive investment, typically an ETF or combination of two ETFs, and occasionally a different, more defensive individual stock. The goal of this rotation was that if the market continued to rise, the investor would likely capture some of those gains, but if the market fell, then the defensive stock would fall less than the target stock, and at a certain point, when the target stock was low enough, the investor could rotate back into the target stock and own more shares than they originally had at little extra cost (other than taxes).
For example, let's say a target stock and a defensive ETF are both trading at $100 per share and I own 100 shares of the target stock ($10,000 worth). I notice that target stock is way overvalued so I sell it and buy 100 shares of the defensive ETF for $100 ($10,000 worth). Now let's say the target stock falls 50% to $50 per share, but the defensive ETF stays at $100 per share. At this point, I can sell my 100 shares of the ETF and take my $10,000 and buy back the target stock that I think has good long-term prospects now that it is fairly priced. Since it only costs $50 per share now I can buy 200 shares with my $10,000. I started the process with 100 shares, but I ended with 200 shares. That is a 100% share gain with no extra cost.
Obviously, there are countless permutations of how this can work out in real life. Sometimes the ETF goes up and the target stock goes down. Sometimes they both go down, but the ETF falls less. And sometimes it doesn't work and the target stock goes up more or falls less than the ETF. But the assumption in most cases is that the target stock is a desirable company and we want to increase our shares at no extra cost.
Side Note: Since I know there are a lot of dividend investors out there I'll take a moment to highlight the dividend growth perspective of free share gains. If you have a stock that pays a 4% dividend, and you increase your shares by 25%, that is effectively the same as increasing your dividend yield by 25% to 5%. In the example above, if the target stock paid a 4% dividend on $10,000 at its peak, you would collect $400 per year in dividends. If you rotated into the defensive ETF and it stayed at $100 per share while the target stock fell to $80 per share and you then rotated back into it, your $10,000 could now buy 125 shares, which is an increase of 25% compared to the 100 shares you started with. Assuming the dividend was held constant at $4.00 per year you would now collect $500 per year in dividends on the same $10,000. Most of the gains we'll see in this article are between 25-60%, and all of them were achieved in less than a year. Those are substantial dividend increases if you ask me, and an important consideration for dividend investors, even if dividends are not the primary focus of my strategy.
I've adjusted the strategy a little bit along the way, which has created a couple caveats I want to mention. The first is that for a couple of stocks, upon final examination after they had fallen to reasonable levels, I decided that I didn't like something about the company so I personally decided not to buy them. 3M (MMM) I decided not to buy, United Technologies (UTX) I wrote about but didn't want to buy, and Carnival Corporation (CCL), I'm still on the fence. But just because I personally decide not to buy something doesn't mean others are of the same disposition. I always try to write my articles so that they will be useful even to those who might disagree with one part of my analysis or who might be in a different situation than me. So, I will treat these as completed rotational ideas even though I haven't ended up buying them, yet.
With the first two stocks I'll review, I initially thought that I would suggest rotating back into them in stages, but after I had thought about that for a while, I noticed that it would be impractical for me to write updates for partial rotations even though when working from a cash position (as I am) I buy in two stages. So, for the first two stocks here, I will let this serve as the final completion of the rotational strategy even though I still might not have a full position in them personally because I am working from a cash position instead of rotating.
Cummins (CMI), was the first rotational winner of the year. My warning article "How far could Cummins fall?" was published January 22nd, 2018, in which I suggested Vanguard Utilities ETF (VPU) was a good defensive alternative. By, July, Cummins' stock had fallen quite far, and I bought a 1/4 position. Here was what the relative performance had been up to that point.
If an investor rotated the remaining 3/4 of the position today, they would gain ~53% more shares. I think that since this spread could potentially tighten during the next year, it would be wise to take that ~53% share gain now, even though someone waiting in cash should probably wait before making a second Cummins' purchase. I now consider this a successfully completed rotational trade.
In my May 18th article "How far could State Street fall? (And when I'll start buying)" I both warned investors of the dangers of State Street and let them know when I would begin buying. I suggested investors rotate out of State Street and into Invesco S&P 500 Equal Weight ETF (RSP). State Street eventually fell quite far between then and October:
I followed up this performance with an article written on October 21st titled "Buying State Street", where I announced that I was buying a 1/2 position in STT and investors could now rotate half of their defensive position back into STT with an ~36% share gain.
After writing this article, and doing some thinking, I decided to do away with fractional rotations, and, at least partially for simplicity's sake, close these rotations all at once even if my strategy working from a cash position was different. As I noted, part of the reason for that was to make tracking the performance simpler, but part of it also was that the spread between the defensive position and the target stock could always tighten even if the target stock continues to fall. It seemed unwise not to take share gains that were often in the range 25-55%. With that said, here is the performance of the other 1/2 of the rotational position for State Street until today:
I only suggested RSP as a defensive alternative for a couple of target stocks in my articles. I had thought that it possessed a little more upside potential than my more conservative ETF alternatives and that it might be a little more defensive than SPY in a downturn if big tech companies sold off disproportionately. So far, that hasn't been the case, but it has been more defensive than STT. One can now rotate the other half of RSP into STT for an ~41% share gain. Averaging the 36% and 41% gains together, I'll close this idea and call it a 38% share gain.
On April 16, 2018, I published an article titled "How Far Could Magna International Fall?" In that article, I warned investors that even though Magna International (MGA) was a great company, the stock price has historically been subject to deep cyclical drawdowns. In that article, I suggested it would be prudent for MGA shareholders to rotate out of the stock and into something more defensive like Invesco S&P 500 Low Volatility ETF (SPLV). I followed this idea up in the November tracking article:
Magna hit that 40% share gain mark the next day, and I noted it in the comment section of the article, so investors who got more defensive in April, would now own ~40% more shares than if they bought and held MGA.
On May 9th, 2018, I published an article titled "How Far Could PNC Financial Fall?". In that article, I warned investors that even though PNC Financial (PNC) was a great company, the stock price has historically been subject to deep cyclical drawdowns. My suggested defensive alternative investment at the time was the PowerShares S&P 500 Low Volatility ETF (SPLV). On October 15th, I wrote a follow-up article sharing the performance:
Back on January 30th, 2018, as the stock market was near all-time highs, I wrote an article titled "How Far Could 3M Fall?" In that article, I suggested while 3M (MMM) wasn't as cyclical as I expected it to be, that it was moderately overvalued, and it would be wise for investors to rotate out of 3M and into Johnson & Johnson (JNJ).
I revisited the idea in October, and ultimately decided that 3M wasn't for me, but at the time, those who rotated out of 3M after my first article could have rotated back in with an ~32% share gain.
On February 1st, 2018 I published an article titled "How Far Could Northrop Grumman Fall?". The thesis of the article was that I suspected we were within three years of a bear market, and since Northrop Grumman (NOC) was a highly cyclical stock which had a high probability of falling quite far during a bear market it would be wise for investors to rotate out of Northrop Grumman stock and into something more defensive. I suggested two ETFs as defensive alternatives PowerShares S&P 500 Low Volatility Portfolio ETF SPLV and Vanguard Utilities ETF VPU. Here is how they have performed since.
The average return of the defensive ETFs is +0.50% while NOC is -31.4%. An investor can now rotate back into NOC with an ~47% share gain. I now consider this a successful rotational trade.
On April 25th, 2018, I published an article titled "How far could Tiffany fall?". In that article, I pointed out that Tiffany (TIF) was a highly cyclical stock which was subject to frequent significant drawdowns in excess of -35%. I wrote a follow-up a few weeks ago and shared the performance:
On March 15th, 2018 I published an article titled "How far could FedEx fall?" The thesis of the article was that I suspected we were likely to begin a bear market within three years and since FedEx (FDX) stock had a history of being very cyclical, the stock price had a high probability of falling quite far in a bear market. I suggested it would be wise to rotate out of FedEx and into Berkshire Hathaway (BRK.B). A few weeks ago, I wrote a follow-up article showing the performance:
On February 7th, 2018, I published an article titled "How far could Emerson Electric fall?". In that article, I pointed out that Emerson Electric (EMR) was a highly cyclical stock which was subject to frequent and significant drawdowns. I suggested that it would be wise for EMR investors to rotate out of the stock and into a 50/50 mix of PowerShares S&P 500 Low Volatility Portfolio ETF SPLV and the Vanguard Utilities ETF VPU. Last week I wrote a follow-up article, and here is the performance.
On February 8th, 2018, I published an article titled, "How far could General Dynamics fall?" In that article, I pointed out that General Dynamics (GD) was a highly cyclical stock which was subject to deep drawdowns in excess of -50%. I suggested that it would be wise for GD investors to rotate out of the stock and into a 50/50 mix of Invesco S&P 500 Low Volatility ETF SPLV and the Vanguard Utilities ETF VPU. I wrote a follow-up article last week and this is how they performed:
On February 22th, 2018, I published an article titled, "How far could Rockwell Automation fall?" In that article, I pointed out that Rockwell Automation (ROK) was a highly cyclical stock which was subject to deep drawdowns in excess of -40%. I suggested that investors rotate out of Rockwell Automation and into a 50/50 mix of the PowerShares S&P 500 Low Volatility Portfolio ETF SPLV and the Vanguard Utilities ETF VPU. I wrote a follow-up this week. Here is how they performed:
On February, 14th, 2018, I published an article titled "How far could Eaton fall?" In that article, I pointed out that Eaton (ETN) was a cyclical stock that tended to have drawdowns over -30% on a regular basis. I suggested that investors rotate out of Eaton and into a 50/50 mix of the PowerShares S&P 500 Low Volatility Portfolio ETF SPLV and the Vanguard Utilities ETF VPU. This week I wrote a follow-up and here is the performance:
On April 2nd, 2018, I published an article titled "How far could Carnival fall?" In that article, I pointed out that Carnival (CCL) was a highly cyclical stock which was subject to deep drawdowns in excess of -50%. I suggested that PowerShares S&P 500 Low-Volatility ETF SPLV would be a good alternative to Carnival. This week I wrote a follow-up and this is how they performed:
This idea would have produced about a 33% share gain.
On February 25th, 2018, I published an article titled "How far could United Technologies fall?" In that article, I pointed out that United Technologies (UTX) was a highly cyclical stock and that during bear markets it tended to drop -30% and during a recession -50% off its highs. I recommended a 50/50 mix of the SPLV/VPU. Of all the articles I wrote in January and February, I was probably the most bearish on UTX because, to be frank, the company's plan to break up seemed like desperation to me. It seemed like their hope was they could basically pump the benefits of their two potential spin-offs and pass them off to new investors. I'm far from an expert in corporate spin-offs, but to me, it looks like a pure greater fools situation. The hope being that UTX can sell their two units for a premium to a foolish public. And under some circumstances, it could work. But who wants to bet on that as an investor? Not me. So I had already decided that I probably wouldn't buy the stock myself back in February even if the price fell. Nevertheless, I don't expect every investor to agree with me on everything, so I've been tracking the performance of my defensive ideas vs. UTX every month since March.
UTX hung in pretty strong until the deal for Rockwell Collins closed and they announced the spin-offs wouldn't take place for a couple of years. The hope of greater fools materializing quickly soon vanished, and the stock fell rapidly along with the rest of the market. The average return of the defensive ETFs was +4.16%, while UTX returned -19.3%. An investor who got defensive after my February article who still likes UTX as a business over the long term, can now rotate back into UTX with ~29% share gain than if they bought and held. Personally, I think this stock goes lower over the next 12-24 months, but I don't see the need to keep tracking it if I have no intention of buying, so I'm marking this as a successful trade and moving on.
These 14 winning rotational trades represent about half of the ones I've written about in 2018.
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The other 14 that I've written about I'll continue to track on a monthly basis until they are complete. My next article will be a follow-up on how those rotational ideas are tracking.
I think if I were to have taken a poll last winter when I started writing this series, very few readers would have thought the sort of performance we've seen so far was possible, but the thing I'm most proud of is that I was able to warn investors about the potential downside of some of the stocks they owned. Some of these stocks have now fallen far enough that I am buying them from a cash position. I have made first purchases of CMI, FDX, TIF, EMR, and STT.
While I'll probably reference the table above in future articles, I no longer plan to publish tracking updates on these stocks since I now consider them complete. If the prices keep falling, however, I will likely be buying some of them and publishing updates on my long ideas portfolio, which I usually do at least twice a year.
Since I know that I'm probably the only writer who is focusing on share gains from a rotational strategy, let me also include the simple performance of my suggested alternatives versus the target stocks and the S&P 500. The average realized returns for the defensive alternatives was +3.43%, the S&P 500 -6.43%, and the target stocks -24.35%. It should be noted that these represent about half of the total I wrote about in 2018. There are 13 more that I will still continue to track each month.
I would be happy to answer any questions in the comments section.
This article was written by
My analysis focuses on the cyclical nature of individual companies and of markets in general. I've developed a unique approach to estimating the fair value of cyclical stocks, and that approach allows me to more accurately buy near the bottom of the cycle.
My academic background is in political science and I hold a Bachelor's Degree and a Master's Degree in political theory from Iowa State University. I was awarded a Graduate Research Excellence Award in 2015 for my research on conservatism.
Disclosure: I am/we are long BRK.B, TIF, FDX, STT, EMR, CMI. 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.