Three Strategies for a Falling Market
When to Rebalance Your Portfolio
A Look at the Current Stock Market
Before I offer any advice on how you can beat the stock market whether it’s going up or going down, let’s take a look at the current stock market environment, which is interesting to say the least. If you’ve found it difficult to get ahead in the stock market this year, you’re not alone. Lots of stocks are getting clobbered every day, the economy took a hit from severe winter storms, and investors have been fooled by the recent rise in interest rates.
The Standard & Poor’s 500 and Dow Jones Industrial Average are near all-time highs. Yet stocks that soared last year are getting wrecked this year. Social media, small cap, biotech and Internet ETFs are all down this year after surging over 40% in 2013. Surprisingly, utilities, real estate, and bond ETFs have produced decent gains in 2014. No wonder investors are perplexed!
Now’s not the time to panic, though! The current stock market is frustrating, for sure, but you can pursue strategies that will lead to better performance in the months ahead.
I recently read an article written by Charles Rotblut, CFA and Editor of the AAII Journal, published by the American Association of Individual Investors. Rotblut wrote extensively about the different actions that investors take when the stock market is falling. His conclusions are backed up by an impressive AAII study.
Investors’ actions generally fall into one of three groups: do nothing, time the market and rebalance portfolios. Charles Rotblut used 26 years of data and concluded that doing nothing, like Warren Buffett, produces the best long-term results.
Many investors sell quickly when the stock market begins to drop to stop further losses. Typically, they sell when the stock market falls 20%, officially falling into bear-market territory. Congratulations if you sold some stocks during the past couple of months to avoid possible damage. The tricky part now is getting back into the market. As Rotblut points out, “if you fail to get back into stocks when the market starts rebounding, lasting damage to your portfolio will likely occur. A very large and significant forfeiture of wealth happens when an investor locks in losses (selling in a bear market) and misses out on big gains (failing to repurchase stocks when the market starts to rebound).”
(Cabot’s growth advisories like Cabot Market Letter have a great record of accurate advice on re-entering recovering markets, so if you want to attempt market timing, you might want to follow its professional advice.)
The Best Strategies
What is the best strategy to use when the stock market begins to deteriorate? According to Rotblut, taking no action produces the best results, although rebalancing your portfolio annually generates good results too. For the 26 years from 1988 to the end of April 2014, taking no action outperformed typical market timing by 58%. Rebalancing every year beat typical market timing by 55% during the same time period.
When to Rebalance Your Portfolio
Rebalancing is the process of readjusting your portfolio to your targeted allocation. For example, if your allocation is 70% stocks and 30% bonds at the beginning of a year and, after a bad year for equities, your portfolio’s allocation could change to 60% stocks and 40% bonds. Rebalancing would prompt you to shift 10% of portfolio from your bond holdings into stocks, bringing your portfolio back in line with your targets.
Rebalancing is a buy low, sell high strategy, which encourages you to buy assets after they have fallen in price. This might be difficult to do, but its benefits in a bear market may convince you of its value. Rebalancing lessens the losses in bear markets and restores a sense of control. Rather than being left wondering what the best decision is for your portfolio based on what the “experts” are forecasting, you can maintain a strategy that prompts you to act and which produces better results.
The Best Solution
A hybrid solution if you feel nervous about the current stock market is to reduce volatility in your portfolio. For equities, this should include switching from stocks with high price to earnings (P/E) ratios, above 35, into high-quality, dividend-paying stocks in less economically sensitive sectors such as health care and utilities. For fixed income, switch into higher credit quality and shorter duration bonds. Switching to higher quality stocks and bonds will preserve your allocation model while reducing some of the volatility. You will give up some appreciation potential when stocks and bonds finally rebound in price, though.
In keeping with my advice to stay fully invested in stocks and bonds, and to switch into high-quality equities in steadily growing industries, I recommend buying Actavis (ACT).
Actavis (ACT 208.25), formerly Watson Pharmaceuticals, is a leading manufacturer of generic drugs. Actavis’ goal is to create difficult-to-produce, off-patent drugs. The merger of Watson and Actavis Group in October 2012 catapulted the combined company into a leading U.S. generic drug company. In addition, the company greatly expanded its prescription specialty drug business when it acquired Warner Chilcott in early October 2013 for $8.5 billion.
Actavis, based in Dublin, Ireland, will take another giant step forward with its proposed purchase of Forest Laboratories for about $25 billion. The deal, due to close in mid-2014, will combine two of the world’s fastest growing specialty pharmaceutical companies. If successfully completed, Forest will add substantial sales and earnings in 2015. The move will also form a multifaceted drug company with an extensive pipeline of new products for future introduction.
Sales will likely advance 29% and EPS (earnings per share) will jump 37% to 14.30 during the 12 months ending 3/31/15. The recent Warner Chilcott purchase and promising new product introductions will spur results. In addition, the Affordable Care Act will boost sales and earnings during the next 12 months and beyond. Sales and earnings growth (not included in my estimates) will be greatly enhanced if the Forest Labs merger materializes.
With a price to earnings ratio (P/E) of 19.9 times current EPS and a PEG ratio of 0.94, ACT shares are clearly undervalued, even though the company does not pay a dividend. I calculate PEG ratios by dividing the current P/E of 19.9 by the sum of the forecast five-year EPS growth rate and dividend yield, which is 21.2% plus 0.0%. Debt is a tad high, but ACT’s expected 2014 cash flow of $24.00 per share will be used to pay down debt quickly. I expect ACT shares to reach my Min Sell Price of 245.68 within one year.
Today’s Special Offer
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And follow me on Twitter at @J_Royden_Ward—I post at least one important stock tweet every day.
Until next time, be kind and friendly to everyone you meet.
Chief Analyst, Cabot Benjamin Graham Value Investor
P.S. In my May 15 Cabot Wealth Advisory, I presented a strategy for selling your stocks in both advancing and declining stock markets. In short, I said you should sell your stocks when they become overvalued and exceed their intrinsic values by a wide margin. Now I’ll be the first to admit that determining when to sell is a lot easier said than done. So I offered my assistance in the form of a subscription to my Cabot Benjamin Graham Value Investor where you can find sell targets (minimum sell prices) for more than 275 stocks. For the price of a subscription, I’ll give you the intrinsic value of your stocks, right to the penny.
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