Market Cycles

A Correction Is A Beautiful Thing...

When it’s market-correction decision making time: 10 do’s and don’ts

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at Reprinted with permission. 

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, even technically I’m told, corrections adjust equity prices to their actual value or “support levels”. In reality, it’s much easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual fund unit and index ETF holders rarely take profits but often take fear driven losses. Thus, when any (minor for now) market hiccup grows into a major meltdown, new investment opportunities always become abundant. But how many of us will be prepared to take action during the entire downward cycle?

  • At the close of business December 20th, the S & P 500 was nearly 16% below the all time high achieved just three months earlier and down roughly 8% for the year.
  • In the 20 years from December 23rd 1999, the S & P has gained roughly 3.5% per year (including all dividends). The NASDAQ has fared much worse, the DJIA slightly better.

Two Major Meltdowns

There have been two major meltdowns during this period. Those whose portfolio content and structure allowed them to view these disruptions as investment opportunities have fared far better than those who did not.
Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation should be tuned in to your long-term goals and objectives. Resist the urge to decrease your equity allocation because you expect a further fall in stock prices. That would be an attempt to time the market, which is (rather obviously) impossible. Asset Allocation decisions should have nothing to do with stock market expectations; they should be tuned in to long term goals and objectives, retirement income even.

2. Take a good, hard look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of high quality, dividend paying, NYSE companies as they move lower in price… I call these Investment Grade Value Stocks. I start shopping at 20% below the 52-week high water mark, and the bargain bins are filling.

3. Don’t hoard that “smart cash” you accumulated during the last rally, and don’t look back and get yourself agitated because you might buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies. “Smart Cash” = dividends + interest + realized gains

4. Take a look at the future. Nope, you can’t tell when the rally will resume or how long it will last. If you are buying quality equities now (as you certainly could be) you will be able to love the next rally even more than you did the last one… as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most Wall Streeters are still just scratchin’ their heads about what to do, well into the upturn.

5. As (or if) the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to Shop at The Gap than meets the eye, and if you are doing it properly, you’ll run out of cash well before the new rally begins.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former "becauses" are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

6. When tending to the income purpose side of your portfolio, and you absolutely must have an income purpose side, add selectively to positions that will help grow the income best. Make this an active management function, as opposed to some form of automatic ritual. The objective should be to grow the income as much as possible while prices are weak.

Rarely, even in our three major meltdowns, did investment grade value stocks cut their dividends; closed end income funds likewise. So long as your cash flow continues unabated, the change in market value is merely a perceptual (and emotional) issue… and you will have the means to benefit from it.

7. Note that your “working capital” is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase yield (on fixed income securities). Examine both fundamentals and price, lean hard on your experience, and don’t force the issue.

“Working capital” is simply the cost basis of all securities and cash in the portfolio. If you use this number, instead of market value, in your allocation and diversification decisions, you will never have to rebalance positions again. You’ll be able to keep the asset allocation on track with each investment decision you make.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of what the Wall Street propaganda mill spits out. Focus on Investment Grade Value Stocks… it’s just easier, much less risky, and better for your peace of mind. Never buy a stock that doesn’t pay a dividend, a new issue (notice how few new issues there are in a down market), or any security that does not have total liquidity. They are, by their very nature, more speculative than most of us need to be.

9. Examine your portfolio’s performance with your asset allocation and investment objectives clearly in focus, and in terms of market and interest rate cycles as opposed to calendar quarters (never do that) and years. The fact that you have your very own personal asset allocation plan should allow you to keep your eye on the ball. Remember, that there is no single index number to use for comparison purposes with a properly designed portfolio, and that, eventually, every portfolio is likely to become part of a retirement ready income program.

Today’s average yield on a well diversified basket of income, equity, and tax free closed end funds, REITs, and MLPs is somewhere between 8.5% and 9%, after all fund expenses. Yes, 8.5% and 9.0%. Unfortunately, only personal, self directed 401k and IRA programs are able to use Closed End Fund vehicles.

With this kind of buying opportunity waiting for you, almost any profit becomes a reasonable one… for the long term good of the enterprise.

10. So long as everything is down, as it is now, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should not be discarded during general or group specific weakness. Unless of course, you don’t have the courage to get rid of them during rallies— also general or sector specifical (sic). Yes, rallies are the time to take losses on things that aren’t doing their job, simply because everything else is!

This applies equally well to stocks that refuse to keep pace with the market or which have cut their dividends, and to income purpose securities whose yields have moved way below normal.

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional grade rear view mirrors. The short and deep ones are the most lovable, the long and slow ones more difficult to deal with. These ten operational suggestions should help you get through the discomfort productively.

Think Cycle, Not Year

Remember, if you overthink the environment or overcook the research, you’ll miss the party. Unlike many things in life, stock market realities need to be dealt with quickly, decisively, and with zero hindsight. Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction: there has never been a correction/rally that has not succumbed to the next rally/correction.

Think cycle instead of year. Smile more.