Sep 302015
 

In Buckeye Country we know championship teams have one thing in common – a good defense. This principle can be applied to the stock market as well. You can’t win unless you have a predetermined defense strategy to prevent excessive losses. I say “predetermined” because either before or at the time of purchase, is the time when you can think most clearly about why you would want to sell. You have no emotional attachment before you buy anything, so a rational decision is likely. Once we own something, investors tend to let emotions such as greed or fear, get in the way of good judgment.

It was clear by the end of last year that the market was running out of steam – justifiably so. After all, we had enjoyed 6 years of uninterrupted appreciation of the broad markets. In anticipation of a slowdown I trimmed positions in more aggressive areas of the market, reduced global exposure and built substantial cash positions allowing us to play good defense but retain the ability to go on offense with that cash once the emotional selling began. Last quarter I wrote to clients:

“I have spent the past two quarters preparing portfolios for at least a 10% pullback in the broad markets. Since I have no crystal ball I rarely place timelines on my expectations. I would be surprised however if we can make it through the end of 2015 without a significant pullback.” 

The pullback arrived August 17th with the S&P500 dropping 12.4% through August 25th. The market bounced over the next couple weeks giving investors a chance to evaluate their portfolios and determine positioning for the next several months.   Sharp pullbacks are good for many reasons, but one reason is that quick corrections bring clarity to the thought process and give an investor a chance to consider if they are properly positioned for market volatility. That introspection might cause an investor to realize they don’t have the confidence in a particular investment they thought they had when the sailing was smooth.

I had just such an opportunity as I was doing my weekly reviews of client portfolios when the market opened down over 1000 points Monday August 24th. As I combed through each portfolio looking for positions that just weren’t going to work due to the changing market dynamics, I only found one – Consumer Staples. Clearly everything was down but the paradigm had shifted for the multinational companies due to an increasingly strong dollar creating overwhelming headwinds for corporate earnings. I allowed the market to bounce and a couple weeks later removed the S&P Consumer Staples holding from many portfolios.

There is not a lot to celebrate during a weak market but I felt with only one position to trim from portfolios the indication was, my clients were prepared for the volatility we anticipated for the fall of 2015. While there is confidence in the individual positions held, we continue to evaluate the weighting given to each position within each portfolio. Earnings season begins in two weeks and though earnings may be decent, guidance will be what investors are paying attention to. I expect guidance to be weak, causing greater volatility during the month of October and providing an entry point for positions we have sought to add for more than a year now.

Though professional investors have the stock “wish lists” out and ready to go, many individual investors are tempted to sell into market volatility. Let’s consider the thought process one should go through when considering moving out of an investment.

The classic axiom of investing in stocks is to look for quality companies at the right price. Following this principle makes it easy to understand why there are no simple rules for selling and buying – it rarely comes down to something as easy as a change in price. Investors must also consider the characteristics of the company itself. There are also many different types of investors, such as value, growth or income focused individuals, each with their own goals and objectives.

A selling strategy that’s successful for one person might not work for somebody else. Think about a short-term trader who sets a stop-loss order for a decline of 3%; this is a good strategy to reduce any big losses. The stop-loss strategy can be used by longer-term traders also, such as investors with a three- to five-year investment time frame. However, the percentage decline would be much higher, such as 20%, than that used by short-term traders. On the other hand, this stop-loss strategy becomes less and less useful as the investment time frame is extended.

If an investor is thinking about selling, they should ask themselves these questions:

  1. Why did I buy the stock?
  2. What changed?
  3. Does that change affect my reasons for investing in the company?

This approach requires you to know something about your investing style. If you bought a stock because your Uncle Pete said it would soar, you’ll have trouble making the best decision for you. If, however, you’ve put some thought into your investment, this framework will help. The first question will be an easy one. Did you buy a company because it had a solid balance sheet? Were they developing a new technology that would one day change the market? Whatever the reason was, it leads to the second question. Has the reason you bought the company changed? If a stock has gone down in price, there could be a fundamental problem with the company or it may just be heading down in sympathy with a broad market decline. Does the quality you originally liked in the company still exist, or has the company changed? If after some research you see the same qualities as before, keep the stock.

If you have determined that there has been a change, then proceed to the third question: is the change material enough that you would not buy the company again? For example, does it alter the company’s business model? If so, it is better for you to offload the position in the company, as its business plan has greatly diverged from the reasons behind your original investment. Remember not to get emotionally attached to companies, and making smart sell positions will become easier and easier.

The point here is to think critically about selling. Identify what your investing style is and then use that strategy to stay disciplined, keeping your emotions out of the market.

Looking Forward

While the biggest downdraft for the S&P 500 was 12.4% from its peak — far below the 20% bear market threshold — the pain inside the index of 500 stocks was far greater at the individual stock level. This week, 253 stocks, or more than half of the companies in S&P 500, were down more than 20% from their highs, according to S&P Capital IQ. That means that half of the index components are already in bear-market territory.

While I believe the market may be trying to price in an economic slowdown, maybe even a slight recession next year, many of the individual selloffs have already been overdone. We have not yet seen an emotional sell off, a sell off that flushes the weak money out of the market creating an excellent buying opportunity for rational investors. The market will test the August 25th lows and if the market can’t hold, the selling will accelerate. While we aren’t there yet, equity prices are becoming much more attractive and the well hedged companies with strong balance sheets are separating themselves, on a performance basis, from their peers. While each investment is analyzed on an individual basis, clients should anticipate small positions will be initiated should the S&P hold the August lows. Or if the market fails to hold, (which I believe will be the case) purchase orders will begin as the S&P nears 1800, nearly 6% down from here.   S&P 1800 would place us in bear market territory and represents a decent support level though solid support on a charting basis is not until S&P 1400.

In the noise of the coming months, remember “everyone’s gotta eat”. The perma bears like Shiller, Faber, Stansbury and others have recognized that in the financial services world, there are two ways to survive; you can either manage client assets, making their portfolio stronger over a period of years- which is very hard, grinding work- or you can scare them and sell them books, newsletters and subscriptions which is relatively easy.   What you, as a consumer of financial news, have to realize is that these guys are talking their books of business, or newsletters. They have a vested interest in scaring you to death.

Those clients who have been with me for 10 or 15 years know I can be as bearish as anyone when the market warrants it. So far, the economic numbers give no indication we are facing the end of the world as we know it or even that a significant 2008 style pullback is in the cards. We are currently in the middle of a typical, normal, healthy market pullback. We will remain focused on what is important as we evaluate each position and each portfolio; revenue, profit, competitive advantage, dividend safety, sector, management quality and legislative risk.

I truly appreciate your business. It is one of my top priorities to be proactive in addressing client concerns at all times but especially during difficult markets. If there is anything we can do for you please don’t hesitate to let us know and feel free to give us a call or send an email with any questions or concerns.

Sincerely,

NewHardingSignature
Michael R. Harding, CFP
President / Portfolio Manager