Mitigating Sentiment Cycles: Ignore Sentiment Cycles At Your Own Risk Part 2

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Includes: GE, JNJ, MMM, SP500, VPU, XMLV
by: Cory Cramer
Summary

In part one of this mini-series, I explain what sentiment cycles were, and I shared a working theory about the factors that contribute to them.

In this article, I will share a fairly simple long-only strategy to help mitigate the danger of holding overvalued high-quality stocks.

The end goal of the strategy is two-fold: avoid really big declines, and increase the number of shares one owned in the high-quality stock without paying more money.

Source

Introduction

In my last article about sentiment cycles, I shared several examples of the stocks of high-quality businesses that failed to produce good returns because of sentiment cycles. In that article, I also shared a working theory about several factors that contribute to these cycles. In this article, I'm going to share a simple, long-only rotational strategy that can help spare investors some suffering and also likely increase their long-term returns.

This strategy will not be new for long-time readers of my work. I started sharing a version of it back in early 2018 when I was mostly writing about highly cyclical stocks. As part of that series, I tested a few different variations of the strategy in real-time, and the core strategy worked quite well. Variations on the core strategy were mixed, but provided some useful information about the logistics of executing the strategy and ultimately improving it. You can read the last update here.

In the specific case of sentiment cycles, I am focusing on the stocks of high-quality businesses that have relatively stable earnings. Sometimes those earnings might fall a little bit during a recession, but usually, they don't fall more than -15% off their peaks. The prices of the stocks, however, are subject to fall much farther than that, and sometimes take decades to recover their sentiment-cycle highs.

So, if you own the stock of a high-quality business that is currently quite overvalued, you might find this article helpful. This is especially true if you would like to sell, but haven't been able to find a suitable alternative in the marketplace after the sale to put your money.

Long-Only Rotational Strategy Explained

In early 2018 I wrote a series of articles called the "How far could they fall?" series. The goal of the articles was to warn investors of the potential downside cyclical stocks had while also offering alternative investment ideas that current shareholders could rotate into while the prices of the cyclical stocks were high. The goal of the strategy was to wait in the defensive ideas until after the cyclical stocks (which I refer to as target stocks) had fallen significantly, then 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 position while they were both priced at $100 per share, then during a bear market, the defensive position 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 price 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. Let's go through each of these steps, one by one.

Identify a quality company: Identifying a quality business is important for this strategy because the goal is to eventually buy back the same stock, just at a lower price. If you misidentify a company as quality when it is not, like, say, with General Electric (GE) or Kodak back in 1999, and you successfully rotated out of the stocks and then bought them back when the prices were much lower, only to have the stocks never recover their old highs again, then that's not a great strategy. I usually only do a cursory examination of the businesses when I first write articles about them and suggest people sell them. I aim for businesses that at least look good on the surface and that I might be interested in buying, but, if the prices should eventually fall down to the level I'm looking for, then before I actually buy the stock (or buying the stock back in the case of someone who was previously long) I examine the business more closely in order to see if there is something that could impede a recovery (like high debt or disruption of the industry they are in). So, for my initial examinations, I make sure the numbers work, and for my final examination, I make sure the business works.

3M (MMM) is an example of this. On January 30th, 2018 I wrote an article about the dangers of owning 3M even though it had been a great business, and I suggested Johnson & Johnson (JNJ) was a reasonable stock for 3M owners to rotate into and wait for 3M's stock price to decline.

Chart Data by YCharts

Over the next 10 months, JNJ's returns were about flat while 3M stock fell -25%. At this point, the rotational trade had been a success, but after a closer examination of 3M, I didn't like how they were borrowing money to buy back shares along with their slow earnings growth rate, so I wrote an article explaining why I wasn't a buyer of 3M at that point. Nothing is lost by selling an overpriced stock and then later discovering it wasn't as high-quality as one suspected and finding something else to buy instead of repurchasing it.

Chart Data by YCharts

3M has continued to lag the performance of JNJ since the original article was published.

Understand when the company is overvalued: This isn't always an easy task, but usually, there is a threshold when the math just doesn't make much sense anymore. For stocks whose earnings aren't particularly cyclical, I examine three of the main drivers of future returns over the next 10-years: sentiment mean reversion, cyclically adjusted organic earnings growth, and shareholder/business returns. (You can read any of my "10-Year, Full-Cycle Analyses" articles to see how this works.) If the returns of the stock over the course of 10-years is expected to be under a 4% CAGR, then the stock meets my threshold of being overvalued enough to sell. One can, of course, raise or lower that threshold, and perhaps adjust it based on interest rates a little bit, but each investor should have a level of expected returns that is simply too low to continue holding a stock.

Get somewhat close at identifying the late stages of the business cycle: This is more important with cyclical stocks than those whose earnings aren't particularly cyclical. With stocks whose earnings are less-cyclical, valuation alone could be enough to trigger a sale. That said, it is important for the valuation to be determined based on a full business cycle, and in order to determine that, one needs to have a general understanding of where they stand in the cycle: early, middle, late, or recession, and how to compare that with the returns over the previous cycle. For this reason, for most stocks, I usually go back to 2006 or 2007 to examine the earnings growth rate throughout the entire period since then. It requires some judgment about where we are in the cycle compared to where we were the last cycle in order to do this.

Correctly identify a more defensive alternative: A "defensive" alternative is specifically what one should be looking for during the late stages of the business cycle, which is when sentiment cycles tend to happen, but not necessarily when they always happen. Often times there will be industries that go through supercycles or sentiment cycles in the early or middle stages of the business cycle, too. For example, something like 3D printing, solar technology, biotech, or health food, could go through a sentiment cycle independently of the businesses cycle. In a case like that, one might not necessarily need to get "defensive" after selling the stock. They could rotate into something as simple as an S&P 500 index (SP500) or even something more aggressive during different stages of the business cycle.

However, right now, I think it is clear we are in the late stages of the business cycle, so I have been suggesting genuinely "defensive" alternatives. During my research and experimentation with the "How far could they fall?" series, I discovered that the most reliable defensive positions are a 50/50 combination of defensive ETFs. The core suggested ETF is Invesco's S&P 500 Low Volatility ETF (SPLV), and the second suggestion is typically either a smaller-cap Low Volatility ETF (since April 2019 I have been suggesting Invesco's Mid-Cap Low Volatility ETF (XMLV)), or a sector ETF that perhaps is historically defensive and undervalued (from January 2018 until April 2019 I suggested Vanguard's Utility ETF (VPU), and it worked very well, too).

One of the things I discovered from experimenting with different defensive alternatives since early 2018 is that while individual stocks can work as defensive alternatives (as the JNJ suggestion worked with MMM) ETFs are much more stable and predictable than individual stocks, and a 50/50 combination of low volatility ETFs and a defensive sector ETF that is undervalued relative to the market make ideal defensive positions while waiting for the prices of the target stocks to come down to more reasonable levels.

Have the guts to rotate back into the target stock: Again, this is much harder with classic cyclical stocks that are driven my earnings cycles than it is for those driven by sentiment cycles. However, it is important to note that the news will probably be bad when the best time to rotate back in is at hand. My suggestion is to decide ahead of time two entry points when you plan to get back in. Base the one entry point on the number of free shares one expects to gain. For example, if you own 10 shares of a stock and rotate out of it and into a defensive alternative while they are both trading at $100 per share, and the defensive position holds steady while the target stock falls to $80, you could at that point afford to buy 12.5 shares of the target stock by rotating back into it. At the end of this rotation, you have gone from 10 shares to 12.5 shares and increased your shares by 25% without spending any additional money. (I usually only use this rotational strategy if there is a high probability of a 20% free share gain.)

The second entry point could simply be based on the valuation of the target stock. When I perform a 10-year, full-cycle analysis, I consider a stock a buy if the expected 10-year CAGR is 15% or greater. It might be the case, that one simply wants to wait until the stock is that cheap before rotating back in. The potential gains using this method are higher, but there is always a chance that the stock never gets that cheap. In this case, an investor needs to be prepared to invest in another stock that is trading at a good price with a margin of safety if the target stock never falls far enough.

An investor can use either one of these approaches, or a combination of both with the rotational strategy. I think a combination of both, using two entry points is best.

Wait for the stock recover: With cyclicals, recovery usually means big gains and taking profits after 2-3 years if there is no recession, and 4-6 years if there is a recession. But one of the wonderful things about less-cyclical stocks is that at long as the business is performing well, you can hold them for much longer time periods. Basically, you can hold them until they become clearly overvalued again, which often takes around 15 to 20 years. Stocks purchased in the 1970s and early 1980s could have been held all the way until the late 1990s in many cases. And many stocks purchased in, say 2002, are just now getting overvalued 17 years later. So, this isn't a particularly active strategy so long as one is doing a good job choosing quality businesses.

Why not go to cash?

It should be noted that the primary purpose of sharing this strategy is to offer it up as an alternative to going to cash or a cash equivalent. If I was better at precision market timing, and I knew that each individual stock would become a 'sell' close to a market top, then going to cash would be better than getting defensive while staying in the market. However, I don't claim to have a special ability to time the top of the market or any particular stock in it.

When one goes to cash because all of the investments that meet their basic quality standards are trading at or above fair value (meaning the implied future returns are not high enough) even if they aren't explicitly saying so, they are making a market call. Warren Buffett's current 120 billion dollar stash at Berkshire Hathaway is a good example of this. Even though Buffett isn't making a macro market determination that it's near a top, he is doing that de facto because he can't find investments $10 billion or larger with an adequate future return and margin of safety. So, he's holding cash until he does. And this cash has been a drag on Berkshire Hathaway's performance over the past several years.

My goal with this strategy is to help investors' performance by staying invested in the market late in the cycle by owning defensive ETFs until it is clear we are headed into a recession. (In the Cyclical Investor's Club I share a high-probability trigger for when a recession is imminent. It hasn't been triggered since January 2008.) Once it is clear a recession is upon us, then we can move the funds we have collected from selling expensive stocks which haven't found a home yet to cash.

The idea behind this approach is for these defensive positions to perform better than cash late in the cycle, even if they might underperform the S&P 500 during that time. But once the economy and market start to go down, these defensive positions should fall less than the S&P 500 (and a lot less than the expensive target stocks). So, these defensive positions are designed to be a happy medium between cash and the S&P 500.

The reality is that since I started suggesting my two primary defensive positions in mid-January of 2018, they have performed far better than expected.

Chart Data by YCharts

The goal was to perform better than cash late in the cycle, but the results with these two ideas have been much better. At this point, I think VPU is fully valued, and I like XMLV better right now, but you can see how much less the two defensive ETFs fell during the late 2018 correction. That is the main reason why they have done so well. But, even though we are late cycle, the SPY is beating cash, too. Holding cash too early can be tough psychologically to pull off as an investor unless you are as seasoned and intelligent as Warren Buffett. And many investors who go to cash too early will be tempted to capitulate and start buying near the top because of fear of missing out. Getting defensive with ETFs is a good way to prevent that. There has been no position easier to hold than SPLV the past year and a half (that includes cash).

It should be noted that defensive positions will decline in value when the market eventually rolls over, but I expect them to decline about 20% less than the S&P 500 and much less than the overvalued stocks one rotated out of. Depending on when the market rolls over, one might indeed have been better off holding cash. But getting defensive instead of going to cash generally gives an investors years worth of leeway in estimating the top of the market because they are still in the market. So, if you're not a great market timer, then these ETFs are a good option.

Conclusion

In part one of this mini-series, I explained why understanding sentiment cycles is important, I listed several historical examples of them, and I shared a working theory as to why they happen. In this part, I shared a long-only rotational strategy that can help investors avoid big sentiment-driven drawdowns, and increase the number of shares they had previously owned by +20% or more for free. In the next part of the series, I'm going to take a look at 10 high-quality large-cap stocks that I have suggested selling and rotating out of this year so far, and how they have faired compared to SPLV and XMLV, the two current ETFs I think offer good defense right now. This will hopefully provide a clearer example of the strategy and how it works in real-life.

Disclosure: I am/we are long XMLV, 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.