What Do Wizards Know?

Embracing Market Corrections: A Four Pronged Strategy

You can always spot ‘newbie’ investors, who often want to ‘see how you do for a year’

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 sanserve@aol.com

One of the great things about being a professional investor is the opportunity one has to apply his or her long-term experience to the investment environment unfolding (or coming unglued) in the present… and in different directions for differing portfolios. If nothing else, most successful investors develop a consistent strategy that allows them to take advantage of short-term changes/opportunities in a somewhat unemotional manner. You can always tell a “newbie” by a “let’s see how you do for a year” comment, or a “what’s hot” question.

Wall Street would like us to ignore the fact that the stock market is a cyclical beast that changes direction periodically, and almost never at the turn of a calendar quarter or year— cycles vary in length, breadth, and direction. Inevitably, less experienced investors get caught unprepared for changing market realities. Similarly, Wall Street wants investors to look at income purpose securities (bonds, income CEFs, preferred stocks, REITs, etc.) with the same total return analytics they use for equities. They too are expected to grow in market value forever, even though it’s the income that the investor should be focused upon.

High total returns usually mean missed profit taking opportunities, and rarely signal an increase in spending money.
Nothing in the nature of income purpose securities (debt instruments) should suggest that they will react to external forces in the same directional manner as equities (ownership instruments).

What The Wizards Think They Know

So, as much as the “Wizards” would like us to believe that up arrows are always good and down arrows always bad for all securities; and that they can get you safely hedged (protect you) against the bad stuff, it just doesn’t work out that way, most of the time. If you are over 30, you already should know this.

Cyclical corrections are a good thing. They cleanse the markets of residual fear and greed, and this time, perhaps, they’ll point out that Modern Portfolio Theory (MPT) spawned, passive ETF products, don’t ever produce the desired stable, and predictable, results…. much less any meaningful income.

Investors in general behave a lot like teenagers. They think that they know everything by listening to a stock market analyst; expect instant gratification; take unnecessary risks; fall in love too easily; ignore the voice of experience; prefer the easy (passive) approach; and feel that the lessons of the past don’t apply to what’s going on now. Duh, dude!

That said, what can the average investor do to protect his 401(k), IRA, or personal investment portfolio from the next major market meltdown? How can we protect ourselves from scams, toxic products, and lemming-like behavior, now, and into the future?

Dysfunctional Decision Making

Protection from dysfunctional decision making requires discipline, patience, and the appreciation of some over-the-counter miracle drugs that have protected countless portfolios from being victimized by past correction viruses.

What if # 1:
In the 30’s, your parents had purchased shares in from 20 to 40 prominent, dividend paying, NYSE companies, and you did the same in ’87, or ’97, 2000, and 2008? Now, what if you had immediately sold all those issues that gained 10%, and reinvested 70% of the profits, keeping a diversified portfolio of similar stocks, and hit “replay” religiously? How much more market value would you have today… and with the taxes already paid?

What if # 2:
At the same time, 30% of the portfolio was placed in high quality income purpose securities, and 30% (of both the income they produced and the equity profits) was reinvested in similar securities. How much more income would you have today than you do now?

Note that asset class calculations need to be based on the “working capital”, or cost basis, of the securities in each of the (only) two asset allocation buckets: growth purpose and income purpose. 

There are some who would say that there are more than two asset allocation “buckets”, but I disagree if the investor can determine the growth or income “purpose” of the security. Also, although dividend paying stocks are certainly of higher fundamental quality than others, they own all the risks of the stock market in addition to some IRE (interest rate expectation) sensitivity. They should be treated as growth purpose securities.

Cash is absolutely not an investment. It is part of the equity “bucket”, waiting for a home. The income “bucket” should always be as close to fully invested as possible.

Investors in general behave a lot like teenagers. They think that they know everything by listening to a stock market analyst; expect instant gratification; take unnecessary risks; fall in love too easily; ignore the voice of experience; prefer the easy (passive) approach; and feel that the lessons of the past don't apply to what's going on now. Duh, dude!

Hindsightful Analysis

If you combined the two analyses above, how much more working capital would be in your portfolio today? This hindsightful analysis should lead you to three portfolio life saving, and behavior changing, observations:

  • One: Every market up cycle produces profit-taking opportunities, and all reasonable profits should be realized — in spite of the taxes. Minimize the taxes by having the growth purpose securities in tax deferred or ROTH investment accounts
  • Two: Every market down cycle produces buying opportunities, and buying activities of two kinds must be continued throughout the downturn (adding new positions, and adding to old positions, both growth and income. Pure income securities are difficult and/or expensive to add to; income portfolios (Closed End Funds) eliminate all the individual issue diversification and liquidity issues… and at much greater yields.
  • Three: Compound income growth is the “holy grail” of investing, so find investment vehicles that can be added to routinely (managed income CEFs) and, if spend you must, always spend less than you make.

Just as the process described above is more difficult to implement (for income growth) with mutual funds and ETFs, so too is this four-pronged strategy for dealing with correction borne investment opportunities.

So, you should reinvest portfolio-generated income leisurely, and according to your planned, working capital based, asset allocation. All the classic diversification rules apply: position size, sector/industry exposure, globality, etc.

  • One: Add new equity positions, in new industries if possible, and keep initial positions smaller than usual. Stocks should be fundamentally ranked B+ or better by S & P, dividend paying, issues of historically profitable companies, and down at least 20% from their 52 week highs. These acquisitions should be monitored closely for quick turnover, at net/net profits of from six to ten percent, depending on the amount of cash available in your portfolio… the less cash, the quicker you pull the trigger on profits.
  • Two: Add new income positions when current yields are unusually or artificially high, and watch for quick profits in this area as well. When yields are normal or lower than normal, diversify into new areas… and embrace this, there’s no such thing as a bad profit.
  • Three: Add to positions in stocks that have maintained their quality rating and dividend while falling 30% or more from your cost basis. If the addition doesn’t produce a significant change in cost per share, return to “one” or “two”.
  • Four: Add to positions in income securities to decrease cost per share, increase current yield, and increase portfolio yield simultaneously. Never allow a single position to exceed 5% of total working capital across all of your accounts. Try to achieve “the most bang for the buck” in your “add to” decision making.

When the going gets tough, the tough go shopping for bargains; when prices become bubblicious, experienced “toughies” take target profits… and use equity CEFs if only a few individual issue bargains are available.