Don’t stop thinking about tomorrow. Even if it won’t soon be here.
Yes, it’s true. The guy who has been warning of a risk-filled stock market for over 2 years is talking about the next bull market. What gives?
You see, investing is a continuous process. You should always be looking to do 3 things:
- - Grow capital from a rising market
- - Hedge against major losses that threaten to impair that capital you made
- - Exploit periods of severe volatility
Over the past decade, we have had plenty of the first one of those three items, and not much of the last two. Starting in late 2016, the global stock market gradually began to crack. But many investors had no idea, even though it was right in front of them.
The stock market “hurricane” – in review
The fourth quarter of 2018 brought the first real test for investors in years. The S&P 500 fell just about 20%, most of that during a 3-week stretch in December. But the decline stopped on a dime on Christmas Eve, 2018. That led to a fierce rise in stock prices. Of course, that same narrow group of companies continued to lead the way.
The S&P 500 has been hiding the stock market’s gradual fade that entire time. Since that index and the Dow and Nasdaq favor a small number of prominent companies, as equity investing surged in popularity the past few years (a la the Dot-Com Bubble era), the details became less important to many people. As long as you had the FAANG stocks, those giant companies that dominate our modern daily lives, you didn’t need to know anything else. Well, now you do.
I have often used the metaphor of a hurricane to describe the U.S. stock market since late 2018. I view that quick decline that ended on Christmas Eve as the front part of the storm. 2019 and the first month of this year were the “Eye” of the storm. That’s the calm period during a hurricane when the weather is bright and sunny. You would have no idea that the back side of the storm is coming, unless you had a weather radar.
The back side of the storm arrived on February 19. The winds had been blowing a bit before that time, but the turning point was the S&P 500’s topping out 4 weeks ago. Here is the S&P 500 in purple. This chart shows how it was the outlier for a while, as global stocks (MSCI ACWI) and small caps (Russell 2000) had already peaked a couple of years ago, but for some brief rallies.
That’s the history. I will continue to write to you about how I progress to navigate that vicious storm. After all, I believe that, despite the likelihood of some strong bounces, this will get worse before it gets consistently better.
I am not a market timer. I do constantly evaluate probabilities. I always have a stance on what and where return potential is, and how much risk is required to pursue that return. Right now, as much as dip-buyers want to pounce on stocks, I say that’s fine. You just have to accept the potential to see your new holdings drop by a breath-taking amount. Yes, that’s always a possibility in the stock market. But that is the case now more than in “normal” times.
I literally cannot find a single stock that I would take a “full” long-term position in at this juncture. That has been the case for a while now. That alone is a market indicator to me. It was a big factor in my sounding the alarm about a severe downturn in stocks earlier this year. That condition has not changed yet. Until it does, stock investing will be a volatile pastime.
Remember, despite the recent selloff, even the S&P 500 sits right near the top of the mountain. Here is what the past 25 years have looked like. In particular, note that bear markets and recessions (the 2 gray shaded periods) have resulted in the market giving back way more gains than this one has in its first few weeks.
BUT: I didn’t say not to invest in stocks
For many investors, there is always a reason to be buying stocks. After all, we never know anything for sure in this business. That’s why every investment ad has such a long disclaimer below it!
Still, we can always look ahead to better times, and do so with discipline, not emotion. For today, here is a short list of things you can start to work on to give your portfolio a great chance to be present and accounted for when that next bull market in stocks gets rolling.
Develop a short list of blue chip stocks you would be willing to take a full position in “at a price.”
Or, if you prefer to invest in ETF or mutual funds, make a list of those instead. For instance, I am current developing a list of potential long-term stock holdings, based on the same Yield at a Reasonable Price (YARP) methodology I have used in the past.
While few, if any stocks are “cheap” in an environment like this, there are several that are starting to get more reasonably valued. That’s enough to at least consider adding them into the portfolio in small “waves” at a time. This is akin to dollar-cost-averaging, except that it will not be done at set calendar intervals. That reward/risk trade-off I mentioned above is what guides this.
Why the focus on blue chip stocks, the business leaders of today? Because regardless of how much you love to buy smaller company stocks, you are fighting a bigger uphill battle than at any time I can remember. There is too much price-insensitive investing going on (algorithmic traders and index funds) to fight that tide.
It creates an environment of “risk-on / risk-off” that reduces the ability to stock-pick outside of the larger companies. That forces us to simplify our equity investing, at least when it comes to the central part of our stock portfolio. That change may be permanent, we’ll see.
Create a “fallen angels” list
Again, this can be stocks or funds. The common denominator is that you are looking for severe price dislocations. These are companies or market sectors that are way, way out of favor. They might even be priced as if they could go out of business. But if you think you have an edge, make that list and monitor them. But realize that there is bigger risk here than in any part of your portfolio. So allocate accordingly.
I always maintain a list of fallen angels. It is about 20-25 stocks. It has been a long time since I have plucked one off the list and put it in the portfolio. But when everything starts to go on sale, we inch closer to at least some of them being buy-able.
Learn to use options as a surrogate for buying (or shorting) securities
Options have a mysterious, eclectic reputation in some circles. What I am talking about is a “meat and potatoes” approach to options. That is, simply looking at any investment you might make, and determining whether you want to go “all-in” at the start. One way to give yourself return potential, but with downside risk limited to an amount you define up front, is to use options.
This space does not permit me to go into the level of detail required. So for now, suffice it to say that options can be a surrogate for committing a larger amount of capital to an investment. And, using options is not mutually exclusive with investing in stocks or ETFs themselves. That is, they can be used in tandem. At a strange time like this, perhaps thinking outside the box is a good thing!
Getting back on the proverbial horse
These 3 ideas may be used separately or together to get your portfolio back in shape, if you have taken a hit recently. However, the most important aspect of this is to have a consistent process of constantly evaluating investments. That process does not change at all from bull market to bear market. The only thing that changes is how many “good ideas” are revealed by your process.
If your process was soundly built, you probably have not had too many good new ideas lately. Perhaps soon that will start to happen again. That’s when you know that the bear market is progressing back toward bull market for stocks. And, that the storm is fading.