Bearish periods are notorious for upending traditional investment strategies. Therefore, maintaining bullish attitudes and approaches is usually futile in a downturn. Instead, we need to adopt a bearish investment strategy to succeed in this stock market.
First: Be fast
Downturns occur quickly. Therefore, investment success requires speedy shifts. Waiting for more information or for the dust to settle are common traps for being caught in the downdraft, then missing out on low-priced opportunities.
Second: Reject “sophisticated” risk reduction strategies
Following a sharp drop that falls well below the “buy on dips” level, a common reaction is to reduce portfolio risk by investing in alternative strategies, funds and issues. Wall Street’s and advisers’ attempts to fulfill this desire typically end up producing confusion and disappointment.
The key problem is trying to allay down market worries while staying fully invested. Currently, Wall Street and advisers are offering “lower risk” solutions that include “low-vol” (low volatility), “alternative,” “hedge fund-like,” and “option strategy” funds and approaches.
The problem? While they do “succeed” at watering down returns, they do a poor job of alleviating risk (both actual and mental). The reason for the poor showing is that the designs necessarily have myopic strategies – holding fewer traditional issues in a less diversified portfolio. Worse, whenever such strategies become popular, poor outcomes are the result.
Third: Invest in some cash
When stocks or bonds produce losses, cash is the clear winner. Additional benefits from holding cash are:
A calmer demeanor that allows making better decisions and avoiding emotionally driven mistakes
The funds for buying attractively priced investments
That last point is especially important. The best route to investment success is to buy low, but that takes cash. Moreover, without cash, fully-invested investors face the hold-low or sell-low choice, an anxiety-ridden dilemma.
Fourth: Reduce importance of stock fundamentals
In normal times, forward earnings and growth potential are important fundamental stock measures. In bearish times, however, they become weak – not because they are ignored, but because the concerns and uncertainties around the fundamentals reduce confidence in the numbers, themselves. Moreover, economists and analysts are slow to adjust to a negative outlook scenario.
Fifth: Avoid screening for stocks to buy
There are insurmountable problems to performing screens in downtrends.
Earnings and growth data are unreliable, as described above. Importantly, they will be just as unreliable at this down market’s bottom, wherever that may occur.
Higher dividend yields (currently being used in articles recommending stocks) are questionable. Stocks are still being analyzed individually, so higher yields mean higher risk. For example, Chevron CVX +0.45%’s 5.7% yield makes it a popular recommendation (JPMorgan just upgraded the stock). The yield is high because oil prices are well below Chevron’s business-based projections. With large capital outflows committed through 2017, there has been little left over for dividends. Although management says maintaining the dividend is important, if Goldman Sachs’ $20 oil forecast is anywhere near the mark, the dividend must necessarily be on the cutting table.
Low price picking has bad rationale (e.g., looking for stocks well below their 52-week highs and/or 200-day moving averages). The problem is that we are in a bearish period and that necessarily means prices are going to be much lower than they were. To screen on “price lowness” is to presume either that those higher prices are still valid valuations, or that some stocks are down too much. Neither is a proper assumption. (Currently 1/3 of the S&P 500 stocks are more than 20% below their 52-week highs and 1/3 are more than 10% below their 200-day moving averages.) This graph shows how the percentage of S&P 500 stocks still above their 200-day moving averages has dwindled and how the current level compares to the past…
The bottom line
This bearish period is not the time to use bullish tools and investment approaches. Important dos and don’ts are:
- Be fast.
- Reject “sophisticated” risk reduction strategies.
- Invest in some cash
- Reduce importance of stock fundamentals
- Avoid screening for stocks to buy
Market returns have become so volatile that daily returns of 3%-5% — up or down — are hardly surprising. Volatility is a cruel beast, because it leads investors to make emotionally based decisions that center on the near term future and ignore longer-term opportunities. Moreover, many investors are staying out of the stock market entirely or selling their equity stakes.
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