Income Lab Ideas: Pullbacks, Corrections And Bear Markets

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Includes: AAPL, BDJ, BME, BST, CSQ, DDF, DIA, DJI, DVY, EOS, ETB, ETO, ETV, EVT, FOF, GAB, GDV, HTD, MSFT, NDAQ, PDT, RIV, RNP, RQI, SDY, SP500, SPY, USA, UTF, UTG
by: Nick Ackerman
Summary

Pullbacks, corrections and bear markets are normal parts of any market cycle.

Corrections and bear markets sometimes take a while to recover, but as we know at this moment, they eventually do.

These are times to be disciplined and keep focused on your strategy, potentially buying if you can stomach it.

Closed-end funds can help an investor stay diversified and have assets professionally managed.

Co-produced with Stanford Chemist.

Investing is one of the key ways to build wealth, no matter who you are. Some people create businesses and become wealthy and successful. Not everyone is destined to build the next Apple (AAPL) or Microsoft (MSFT) though, and that is okay! The fact of the matter is that for the average person - this just won't happen. This is where investing comes in handy to build wealth over our lifetimes and build us an income in retirement.

Some choose to focus their energy on specific sectors or strategies. These are too numerous to list all of them. I prefer to invest a good chunk of my wealth in closed-end funds, or CEFs as it is generally abbreviated. Some key benefits of CEFs can include: funds trading at premiums/discounts, diversification and professional management, to name a few specific factors.

I choose CEFs for diversification. Diversification significantly helps with limiting single stock risks. When an investor owns individual companies they are tied to the mercy of how that one company performs. The other significant benefit of CEFs is the higher income that they can produce compared to other investments.

However, this isn't an article solely focused on CEFs, and could be a good refresher for any investor!

Brief Economic Lesson

(Source - Morningstar.com)

A simple business cycle chart that is representative of the usual pattern for the economy. The economy has gone through this cycle many times, since forever.

This is quite similar to the stock market's cycles. For a brief economics lesson, there are three categories of economic indicators: leading, lagging and coincidental. The stock market is generally categorized as a leading indicator. However, this isn't necessarily true and I'm not sure why this continues to be propagated as such. To help explain my feelings on this I can use a piece from Investopedia that helps explain this in better words than I could:

In order for an economic indicator to have predictive value for investors, it must be current, it must be forward-looking, and it must discount current values according to future expectations. Meaningful statistics about the direction of the economy start with the major market indexes and the information they provide about:

  • Stock and stock futures markets
  • Bond and mortgage interest rates, and the yield curve
  • Foreign exchange rates
  • Commodity prices, especially gold, grains, oil and metals

Although these measures are crucial to investors, they are not generally regarded as economic indicators per se. This is because they do not look very far into the future - a few weeks or months at most. Charting the history of indexes over time puts them in context and gives them meaning. For instance, it is not terribly useful to know that it costs $2 to purchase one British pound, but it may be useful to know that the pound is trading at a five-year high against the dollar.

Essentially, what the excerpt is saying is that the stock market is too short-term focused and doesn't give us enough context as to what will happen next.

Stock Market Cycles Within Economic Cycle

As previously mentioned, the stock market goes through these same cycles. There are, however, three normal movements that every investor should be aware of that are just as normal as the business cycle above. These are pullbacks, corrections and bear markets. Bear markets will happen during times of recessions. However, it doesn't always have to be a recession to occur, like we witnessed at the end of 2018.

To put these terms into specific definitions, a pullback is when the market (or stock) makes a 5% downward movement from peak to trough. A correction is a 10% downward movement, and finally, a bear market is generally defined as a 20%+ drop from peak to trough.

While these events are normal and healthy, it is still concerning to some investors. But every time this has occurred it has been a buying opportunity. Every single time, this is backed by the broader markets hitting record highs. Bluntly speaking, if an investor had purchased the S&P 500 at any point in the past, they are up.

Pullbacks

Defined as a 5% drawdown from peak to trough. This is the most frequent of the downward movements. These can occur in individual stocks and the broader market as a whole. They are generally only a few trading sessions in length.

These can be brought on by a slightly poor earnings miss for a company, or potentially a CEF that rises sharply too fast and pulls back more in line with its NAV movement.

Corrections

This is generally a less frequent occurrence and is defined as a 10% drop in a stock or market index. Corrections are where things start to get a little more exciting and buying opportunities start popping up!

The type of news that gets the market to correction territory is generally more severe in nature. This can include a big earnings miss from a company, poor economic news or a significant political event. These types of events usually lead to the market "over-correcting" as panic spreads. That's why a prudent investor will be looking for these opportunities to pick up shares of a watchlist stock or CEF.

These too, like pullbacks, are completely normal. In fact, these occur every 1 to 2 years on average.

Bear Markets

And finally, bear markets, these are when the panic becomes completely widespread. Everyone is selling everything and trying to get out of the door at the same time. These aren't quite as frequent, occurring 10 times since 1956, as the chart below indicates. This gives us a bear market, for this specific period, of happening every 6.3 years. Please note that the latest bear market at the end of 2018 is not represented in this graph.

(Source - Investopedia.com)

This chart is a fantastic example of why a bear market should not be feared. It gives us visual confirmation of the overall big picture.

Overall, bear markets are caused by many things. The latest one was truly unique. The average bear market takes around 22 months to recover, the latest taking only a few months. The prior crash that was more significant than the latest, was more memorable.

The Great Financial Crash, caused by mortgage-backed securities and took many financial institutions down with them. We are still feeling its effects today too. The low-interest-rate environment that we have right now was caused by this crash. That's even when the markets have fully recovered from the lows. However, it did take an extremely long 6 years to recover from the lows.

In addition to that last severe crash, the dot-com bubble was just as traumatic, even if not remembered quite so well by today's investors. Of course, this was when many tech names became utterly overvalued and came crashing back to reality. The dot-com crash took an even longer recovery time, 8 years!

Again though, a long-term investor would have been rewarded for their patience and discipline. In the CEF/ETF Income Laboratory, we have a portfolio designed with high-quality names, the Income Generator portfolio is designed with the stability of income in mind. Additionally, we have our Tactical Income - 100 portfolios designed to take advantage of these times of volatility through arbitrage.

Long-Term Investing Wins - Quick Example

Now, this is why I choose to focus on CEFs. There are plenty of times in history that individual companies have gone bankrupt and cease to exist. If every underlying holding in a CEF declared bankruptcy and shares went to $0 overnight, then my thoughts are that I would probably be more worried about world anarchy than money.

I'm always investing with a long-term focus in mind as well. To name a specific example of a CEF recently covered, Cohen & Steers Quality Income Realty Fund (RQI).

Chart

Data by YCharts

As you can see, RQI sharply rose right before the Great Financial Crisis, before plunging lower. Using CEFConnect pricing data, and the best of my ability to pinpoint the highest mark that shares traded at, we arrive at a share price of $25.91 and a NAV of $28.04.

If an investor would have bought shares of RQI at that exact time on December 4th, 2006, they would have still made a positive return. This is when factoring in distributions. If an investor had held shares since that date, they would have collected:

  1. 4 monthly payments of $0.145
  2. 21 monthly payments of $0.15
  3. 2 special distributions one being $2.08 and another $1.40
  4. 1 monthly to quarterly conversion payment of $0.1325
  5. 5 quarterly payments of $0.095
  6. 14 quarterly payments of $0.18
  7. 4 quarterly payments of $0.19
  8. 7 quarterly payments of $0.24
  9. 36 monthly payments of $0.08

Which gives us a total of $15.6575 per share in distributions, if held through that whole period of time. The current price trades at $14.03 and has a NAV per share of $14.13. This means an investor would have still profited. Not a significant profit or anything as this works out to a 14.57% return. Of course, that is holding for 13 years. This also doesn't take into consideration taxes or inflation - depending on your tax bracket.

In contrast, it is also considering that an investor didn't reinvest any of those distributions and that they bought at the exact worst time! This is also a real estate focused fund, and it had felt very much the brunt of the 2008/09 crash. So, we can take this a step further and look at total returns with distributions reinvested. We arrive at a much better return of 99.89% over that time.

This is why focusing on just the NAV price, and that it is lower than before the crash is not giving an accurate reading on what an investor's performance would be. An investor may also be concerned with the distribution being lower than previous to the crash as well. But we need to keep in mind. The monthly rate of $0.15 worked out to a distribution yield of 6.94%. The current yield of RQI, as calculated with its $0.08 monthly payout, comes to 6.81%.

Concluding takeaway: The total return is more important than share appreciation in CEFs. Taking the worst-case scenario in RQI, we found that returns would have still been positive. Even spectacularly positive if distributions were reinvested.

Conclusion

(Source - macrotrends.net)

The above is a chart of the S&P 500 Index for the last 90 years. The S&P 500 actually goes back just a bit further than this chart. It was created in 1923 by Standard & Poor's (formerly known as Standard Statistics Company). The company originally started with an index consisting of 233 U.S. stocks, then created an index with 90 companies. And finally, in 1957, they created the S&P 500 containing 500 leading U.S. companies. This is another graph to take a look at the bigger picture!

The chart includes the U.S. recessions marked as gray bars (bear markets.) This is important to note as we are hitting all-time highs. Just think about it, the market is hitting all-time highs. This is even after all these recessions have taken place, and at the time of these recessions, I'm sure the headlines were making it seem like the end of the world. But here we are, all-time highs, we survived. A quote that is said many times is "bull markets don't die of old age." And I firmly believe this is true, there is always some catalyst that (temporarily) creates one of the three discussed downward movements.

Pullbacks are a normal part of investing, corrections and bear markets are buying opportunities for those that can remain disciplined during times of panic. Remain focused on your strategy and consistent and you will survive too, just like all the other times before.

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Disclosure: I am/we are long RQI. 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.