Beginning in mid-January of 2018, I wrote a series of articles that examined how far some popular large-cap cyclical stocks might fall if we were to have a downturn within the next three years. 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 cyclical stocks in question. The four most frequent alternatives I suggested were Invesco S&P 500 Low-Volatility ETF (SPLV), the Vanguard Utilities ETF (VPU), Berkshire Hathaway (BRK.B), and Invesco S&P 500 Equal Weight ETF (RSP), or some mix of them. I called this series of articles the "How far could they fall?" series. The goal of the articles was to warn investors of the potential downside these stocks had, while also offering alternative investment ideas that current shareholders could rotate into while the prices of the target stocks were high. Then, after the target stocks had fallen significantly, rotate from the defensive positions back into the target stocks. The idea was that this process would prevent buy-and-hold investors from suffering big declines while also producing free share gains in the target stocks compared to a buy-and-hold strategy.
For example, if one rotated out of the target stock and into the defensive ETF while they were both priced at $100 per share, then during a bear market the defensive ETF dropped to $80, and the target stock to $40 per share. At that point, you can rotate back into the target company stock and own twice the number of shares at no extra cost. Then, when the stock eventually recovers, you have doubled your wealth compared to what it would have been if you held the target stock through the entire period (minus taxes, of course).
In order for all this to work, one needs to 1) identify a quality company, 2) understand when it is overvalued, 3) get somewhat close at identifying the late-stages of the business cycle, 4) correctly identify a more defensive alternative 5) have the guts to rotate back into the stock when it looks like the world is ending near the bottom of the cycle, and 6) wait for the stock to recover.
The "How far could they fall?" series essentially takes investors through this process with a fairly wide swath of large-cap names. In total there were 28 stocks in 2018 that I both wrote a warning article about, and also offered a defensive alternative I thought would be better at the time. There were a few stocks I wrote "How far could they fall?" articles on that I decided not to offer alternatives on like Ross Stores (ROST) and T. Rowe Price (TROW), that were too hard to predict at the time. I didn't track those. And there was one that I recognized should have been put in that category a few months ago, W.W. Grainger (GWW). I noticed after I reread my original Grainger article that I explicitly said in the article Grainger's turnaround was too hard to predict, and I didn't even perform a risk/reward analysis on it because of that, but then I went ahead and offered an alternative idea anyway, which I shouldn't have done. I kept tracking Grainger's performance until the end of November when it was nearly perfectly even with my suggested alternative, and I decided to correct my mistake, call that idea a wash, and stop tracking it. So, going into 2019 we were tracking 27 large-cap cyclical ideas and how they were performing vs my chosen defensive alternatives.
The deep correction that started in October and bottomed in December created an opportunity to rotate out of many of the defensive alternatives back into the target stocks. I wrote a fairly detailed description of those moves in my article "Tracking How Far They Fell: 2018's Rotational Winners", in which I went through all 14 of the 27 rotational ideas I'd been tracking that had been completed in 2018. We added one more completed rotation with Caterpillar (CAT) in January 2019, and one more new stock to track with Realty Income (O) in February 2019. Here is the table, which shows the free share gains achieved from the rotational strategy for the 15 completed rotational trades so far:
|Ticker||Free Shares Gained||Ticker||Free Shares Gained|
These are great gains, all achieved in a year or less. For those readers who aren't used to thinking in terms of free share gains, here were the average returns during the times when we were out of these target stocks and in the defensive alternatives: Defensive Alternatives: +3.42%, S&P 500: -6.22%, Target Stocks: -24.80%. So, for a group of 15 stocks, we had incredible outperformance while we were rotated out of them, and we even significantly outperformed the S&P 500 with this group over this time period (I'll combine this realized performance with the positions we are still tracking at the end of the article to give us a fully rounded view of how the strategy is performing.)
As I wrote about these stocks in 2018, I essentially covered them from two different perspectives. One perspective of someone who already owned the stock and liked the prospects of the company long-term, but who didn't want to suffer unrealized losses during a downturn or who wanted to gain more shares of the company they liked for free by using a rotational strategy. And another perspective of someone who was waiting in cash, trying to buy the stock at the best price possible. The person who was waiting in cash was typically waiting for a lower 'buy price' for the stock than someone who was just trying to avoid a big decline and pick up some free shares. For those reasons, of the 15 stocks above where I said "Now is a good time to rotate back in.", only 5 of them fell far enough to buy if one was waiting from a cash position. I personally bought all 5 of them: State Street (STT), Tiffany (TIF), Emerson Electric (EMR), FedEx (FDX), and Cummins (CMI). Let's take a quick look at their performance.
Performance of Cash Position 'Buys'
Of the five stocks I purchased from a cash position, I have taken profits in two of them already, Cummins and Tiffany. While Cummins I had originally purchased for a bounce that I expected to occur before the next recession, the market had an odd 20% correction and recovery occur in the fall of 2018 that provided rotational and buying opportunities, but we still didn't really move from our 'late cycle' position with regard to the business cycle. So, I've been going ahead and taking 20-30% profits if I get them from the stocks I purchased. Since I'm a conservative investor, I figure that there is no sense in being greedy when we are still probably late cycle. Here is what I made on Cummins and Tiffany relative to the S&P 500: Data by YCharts
So, solid outperformance on realized returns from those two purchases. Now let's look at the three I'm still holding.
I wrote my follow-up article for Emerson Electric on December 21th in which I announced the prices I thought were good entry and rotational prices for the stock. On the next trading day, December 24th, Emerson hit that price.
The stock has been performing very well and is slightly outperforming the S&P 500. If it takes another leg up, I'll probably take profits.
In the case of FedEx (FDX), it was falling so fast that it hit my buy price on the very day my "Here's the price I'll start buying FedEx" article came out on December 20th, 2018.
Since then, it has been performing pretty much the same as the index. I plan to continue to hold this one for a while.
And the last one of this bunch I bought in October and am still holding is State Street (STT).
This is one that I have grown less optimistic on as time has gone on. I think it will do okay, but I think there are higher quality opportunities available in the market. If this purchase gets positive and back to even with the index, I might trade out of it for greener pastures.
Since buying these 5 positions, they have returned +15.24% compared to the S&P 500's +11.22%. That's pretty solid outperformance so far.
Performance of post-rotational stocks
I thought it would be interesting to look at the performance of the 10 stocks that I didn't buy from a cash position, but that I thought the time had come to rotate back into from the defensive positions for those investors who may have who heeded my warnings about the dangers of the stocks back in early 2018 and gotten defensive.
For Magna International (MGA) we hit our 40% share gain goal on December 10th, 2018, at which point I thought it would be a good idea to rotate back into the stock for those who liked the long-term prospects of the company who had rotated out.
It had a big initial bounce and is still slightly outperforming the index.
United Technologies (UTX) wasn't one I was particularly bullish on, but after tracking it all of 2018 and achieving a good rotational share gain, I called it good at the end of 2018.
It has outperformed fairly well for anyone who rotated back in at that point.
Similarly, 3M (MMM) was one I decided to hold off on personally, but let investors know at the end of October they could rotate back in with solid gains if they wished.
Again, there has been pretty solid outperformance since then against the index.
Here are several others' performances versus the index since rotating back in.
PNC Financial (PNC) pretty close to market average returns.
Since achieving big share gains with Northrup Grumman (NOC) at the beginning of the year, it has performed pretty similar to the market, albeit with more volatility.
General Dynamics (GD) has had pretty similar relative performance as NOC since rotating back in.
Rockwell Automation (ROK) has been doing pretty well since rotating back in.
Solid outperformance from Eaton (ETN) since rotating back in as well.
Carnival (CCL) had been doing well until a couple weeks ago. I haven't been following this one, so I'm not sure what is going on with the price drop.
Caterpillar (CAT) is one I wasn't too bullish on but ended the rotational idea on January 15th, 2019. It has been struggling a little bit to keep up with the index since then.
I thought taking a quick look at these would be interesting. Most of them are doing very well on an absolute basis and many are outperforming the index since rotating back in. I think that overall my method of estimating when they were overvalued, and when they were reasonably valued, was excellent with this set of 15 out of 28 total stocks. After rotating back into these ten stocks, on average they have returned +12.37% versus the S&P 500's +12.42%. Virtually identical performance to the index, which is actually quite good, because, remember, with these stocks, we made money by increasing the number of shares we owned. By avoiding the big sell-offs, the average percentage of shares gained was +36.33%. Put another way, if you owned 100 shares of each company, you would now own 136 shares of each company on average, and the stocks are matching market returns since then, so nothing was lost in the process other than transaction costs and potentially the cost of taxes. That's a remarkable return by any measure.
Now let's move on to those rotational ideas that are still running. Most of these, with the exception of Nike (NKE) and Realty Income (O) I have been tracking for 6 months to 1 year. When I performed the initial analyses I assumed 3 years maximum for the start of a recession or serious economic slowdown and bear market (and probably another year after it started for the prices to drop, depending on which stock we were examining). So, now, we only have about 2 years left on the recession or slow down expectation, and perhaps a little while after that for the prices of a few of these to come down. If we get to the end of 2020 and there are no signs of a slowdown, then I'll call an end to tracking those stocks that are left, and we'll take account of where we stand at that point. So, there will be a day of reckoning, even for these stocks we are still waiting to fall.
Stocks we're still tracking
We have 13 rotational ideas we are still tracking, waiting for a good point at which to rotate back in from the defensive positions. Let's see how they are tracking.
The longest running of the ideas, and the elephant in the room at the moment, is Boeing (BA). I think it is fair to say I've caught more grief from Boeing shareholders since I wrote about it in January of 2018 than any other stock I've written about in this series. One of the reasons I diligently follow up on all of the ideas in this series and don't just cherry-pick the winners to follow up on, is that I know that I can learn more from my mistakes than I can my winners. And even if something doesn't turn out to be a big mistake, revisiting these ideas each month forces me to think about them and perhaps notice things about them that I wouldn't have noticed before, especially if those things weren't necessarily obvious without a deeper or more nuanced understanding. With that said, here is my current take on Boeing.
I think my initial assessment of Boeing was correct in two important ways. The first was that Boeing is a deeply cyclical stock. I demonstrated that by sharing Boeing's historical cyclicality. The second thing I got right was that Boeing's price and expectations for future performance were high at the time. (I think I also got my assumption that we were likely in the late stages of the business cycle correct as well, but we won't know for sure about that for a couple of years.) When a stock carries a price with very high expectations, it doesn't necessarily mean that it can't meet those high expectations. Sometimes stocks are expected to perform very well and then they do perform very well. Boeing, for 2018, met those high expectations. That's why the stock went on to make new highs in October of 2018, and again in February of 2019. The business performed very well.
But, one of the reasons the odds are on the side of the 'under' when a stock gets fully priced, is that any disappointment can cause the price to fall quite a lot. And that is what has happened with the 737 Max. To make things more of a tug-of-war when it comes to the price of the stock, there are a lot of investors who have very recently made a lot of money with Boeing stock. I think the past three years it has outperformed about every other stock in the Dow, and it also had an incredible run off the bottom of the recent correction. I think investors who are up big in the stock are reluctant to let it go because they see a bright future down the road and they don't want to miss out.
And honestly, it's a tough call to make. Anyone who has read my past articles and the comment sections of those articles knows that I've never denied the longer-term prospects for Boeing are good. But I think the risks to the downside over the medium-term still outweigh the potential gains. Here is how it has performed versus my suggest alternative SPLV since my January 2018 warning article.
After whipsawing up and down through this time period Boeing is outperforming the index, but slightly underperforming SPLV, which has given investors a much smoother right and significantly outperformed SPY as well. For rotational investors, I would still be waiting for an opportunity to gain at least 15% more free shares before rotating back in, and if you get a big news-driven down day, you might be able to get 20%. From a cash position, I would still wait for -40% drop from highs before buying.
Deere (DE) is one we might be able to rotate back into if we get a decent correction in the next few months. It's almost back to even after trailing the index for most of last year, but the defensive alternative VPU has been dramatically outperforming both of them.
Boeing and Deere are the only two industrial stocks out of a dozen I originally covered which we haven't rotated back into yet with big share gains. The service sector, which is where we will turn to next, has been holding up much better. Part of that has to do the fact that I chose Berkshire Hathaway as the defensive alternative for many of the service sector stocks and Berkshire has been underperforming. And part of it is simply that services have generally been strong.
Union Pacific (UNP) is interesting because I mentioned all three defensive ideas as possible alternatives so we get a look at all their performances from the same date last March. UNP has outperformed everything so far while Berkshire is lagging. Notably, Buffett recently said that Burlington Northern's business had been showing signs of slowing down a bit, which is something I predicted for railroads by this summer. Neither UNP nor CSX (CSX) stock price is reflecting that potential slowdown yet, but I think they will within a matter of months.
Again, like UNP, CSX is at all-time highs. I would be a profit taker here if I was still in them (but, of course, I said that last year at this time as well and it's up 37%).
Much the same pattern with Costco (COST) as we have with the rails. I do expect Berkshire to hold up much better in the event of a recession because they will likely be buying back lots of shares and Costco is priced for perfection.
S&P Global (SPGI) has bounced pretty strongly off the bottom of the correction.
Southwest (LUV) has been showing some weakness, and I think we'll eventually get an opportunity to rotate back into this with a decent share gain.
Paychex (PAYX), while overvalued, in my opinion, is one, like Costco, where we'll probably be looking to get back in and break even. Paychex wasn't a good candidate for this strategy because it has cyclicality that is usually synchronous and about as deep as the market. Additionally, one of the things I learned during this process was that ETFs make better defensive alternatives than individual stocks, so, even though I think Berkshire will hold up well during a recession, there is more individual stock risk with Berkshire, which is something we want to avoid using this strategy, even though, sometimes, it pays off, like with my example below:
In this case, the inclusion of Fiserv (FISV) along with VPU, has shown great outperformance, but even though this one is working out, I would stick with a 50/50 mix of two ETFs when choosing defensive alternatives in the future because it is a more reliable strategy.
Best Buy (BBY) is interesting for a couple of reasons. The first is that I chose an equal weight ETF RSP for the defensive alternative, and it has underperformed the regular index. The second interesting thing about this one is that we might have simply been aiming for too high of share gains. We could have rotated back in December and made solid gains, but I thought more gains were on the table (and I still think they are). So, this will either be a lesson of missed opportunity or one of patience. Time will tell.
Progressive (PGR) is doing well, but it showed how fast it could fall during the correction. If we get an economic slowdown, I think we'll get a decent opportunity for share gains still with this one.
Nike (NKE) is one where the equal-weighted position in RSP is holding us back a little bit, but I'm pretty confident that we'll see the price in Nike fall further.
And last but not least is Realty Income (O), which is a new idea from 2019.
So far, Realty Income has continued to outperform, no doubt driven by the Federal Reserve's interest rate posture and the drop of the 10-year treasury yields the past couple of weeks. It's going to be interesting to see how this one plays out over time. The defensive positions are beating the index, though, so that's a positive.
The final results from the day of publication of each warning article through the end of March 2019 for the 13 ideas we are still tracking are: S&P 500 +5.58%, Defensive Alternatives +7.57%, and Target Stocks +9.71%. That's pretty good when you consider that I only wrote about stocks that I considered reasonably high quality large cap stocks that I might want to own myself. These weren't short ideas. I really wanted to test my rotational strategy using the stocks of good companies that investors might be tempted to buy as long-term holds. In the conclusion I'll share the results if we combine both the 13 unrealized ideas in this section with the 15 completed ideas.
If we combine the results through March for all 28 ideas, the S&P 500 returned -.74%, the Defensive Alternatives returned +5.35%, and the Target Stocks returned -8.54%. While not exactly a scientific study, this group contains 28 stocks, most of which were written about over an 8 month time span and compared with the index along the way. Interestingly we haven't had a recession yet, but since the stocks were mostly evaluated on price movement, the 20% correction we had was enough to move the more volatile of the group to low enough prices to rotate back in even without having experienced a recession. Most of the stocks remaining will only drop if the economy actually slows down. Now we just have to wait and see if that happens within the next couple of years. I intend to follow up each month until them and see what we can learn.
Disclosure: I am/we are long BRK.B, EMR, FDX, STT. 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.