"Buy good stocks in a bad market" is a great strategy--but what does it mean?

08/07/2012 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

Buy good stocks in bad markets. I’ve been hearing that advice frequently in the current “bad” market. I even offered it myself last week in an interview on Bloomberg radio.

And it makes immediate sense, too, doesn’t it? I can think of a lot of reasons to buy into this advice. In a bad market you want to own solid blue chip stocks because they won’t go down as much as other stocks. In a bad market you want to own shares of those few good stocks that go up—Apple (AAPL) for instance—even when everything else goes down. In a bad market you want to own good stocks that pay decent dividends because those stocks will pay you as you wait for the return of the “good” market.

You do see the problems with those reasons though, don’t you? They actually assume different definitions for a “bad” market. And those differing definitions for a “bad” market point toward very different definitions for a “good” stock. And that in turn leads not to one strategy but several different ones that all can claim the title of “Buy good stocks in bad markets.”

So let me try to pick apart those assumptions and definitions so that we can distinguish the different flavors of “Buy good stocks in bad markets.” I think will lead us to a couple of strategies that you can mix and match as the “bad” market continues to evolve. On Friday I’ll flesh out these strategies with some specific stock examples.

Let’s start with the question of exactly why we call this a “bad” market.

If you look simply at the market’s gain to date—that is from the end of December 2011 through the close on August 3, calling this a “bad” market seems just plain wrong. For that period the Standard & Poor’s 500 stock index was ahead 10.6%.

Of course, if you had measured the S&P 500’s performance a little more than a week earlier—on July 25—the index would have shown just a 6.4% gain for 2012.

And if you went back earlier to June 4, the summer low so far, the gain for the S&P 500 from the end of December through that date, was just 1.6%

And if you’d had the misfortune to buy at the high for 2012 to date at 1419, back on April 2, in a belief that the rallying market would keep on rallying, you’d have still been underwater at the August 3 close of 1390.99.

That slight loss would still be much better than the big 9.9% loss that an investor who bought on the April 2 high and sold at the June 4 low would be have recorded.

So what do we mean when we call this a “bad” market?

Two very different things, one looking back and one projecting ahead.

First, we look back and say this is a bad market because of the unnerving—and potentially costly—volatility in stocks. The kind of swing to the upside in the last two months—an 8.8% gain for the S&P 500 from June 4 through August 3—and in the last week—a 4% gain from July 25 through August 3—is great. Until you look at the downside volatility like the drop of 9.9% in the two months from April 2 to June 4.

Looking backward we’re afraid that this will be another bad market like that of 2011 when extraordinary plunges, like that from July 6 through August 10 (down 16.3%), and extraordinary surges, like that from October 3 to October 26 (up 22.1%), wound up producing a net gain of all of 2.12% for the year.

Second, looking forward, we say this is a bad market because we not only expect unnerving volatility, but also a net loss for the year.

Here we’re projecting based on our read of global macro trends. If you believe that the EuroZone countries haven’t fixed the euro debt crisis and those economies will slide further toward recession in the next 12 months, if you worry about slow growth in the United States and the danger that the fiscal cliff the country faces in January will slow growth even more, if you think China ‘s economy is headed toward a hard landing, then you don’t believe that last week’s rally will hold and that the market will break above the April 2 high for the year of 1419 any time soon. In fact, there’s a good chance that you believe that the 2.12% gain for 2011 may look mighty good come December 31, 2012.

And you don’t have to be 100% convinced that either volatility or macro trends are as negative as this for the current market to qualify as bad. All you have to believe is that the likelihood of these negative scenarios is reasonably high for these possible outcomes to scare you. If the odds are just 50/50 in your calculation, for example, then this could well be a “bad” market because that’s just too much risk for you to take—especially if the potential returns are relatively modest.

We all know some of the strategies for coping with normal bad markets. If we’re scared of volatility, we can move to the sidelines—cash, among other possibilities—until the volatility falls to something like “normal” levels. We can buy blue chips because they don’t fall as much in market retreats. We can increase our allocations to defensive sectors—consumer staples, for example—because stocks in these sectors fall less and even frequently advance in turbulent times as investors are willing to pay for safe havens.

If we’re worried about a general market retreat, we can employ some of those same strategies, and then add a few. We might look for stocks that have demonstrated a track record of rising when the rest of the market tumbles. We could even decide that we’re contrarians willing to buy low to sell high.

But how about in an abnormal bad market like the one that seems to stretch before us? It should already be clear that this economic slump isn’t your standard run of the mill recession. We’re now five years into the turmoil that was unleashed in 2007 with the meltdown in the U.S. mortgage market. In 2006 U.S. housing prices abruptly went into reverse, falling 3.3% from the fourth quarter of 2005 to the first quarter of 2006. The drop accelerated in 2007, taking 25 subprime lenders into bankruptcy in February and March 2007 alone. The effects have rippled out across the global economy and we’re still working our way through the consequences.

The kind of global de-leveraging that a financial crisis like this requires means that investors aren’t looking at anything like the traditional V-shaped bust and recovery. U.S. consumers have begun to deleverage—the total debt service paid by U.S. consumers fell to 14.22% of disposable income in the first quarter of 2012 from a high of 17.68 in the third quarter of 2007. That brings the ratio close to the 13.4% in the first quarter of 1981. Much of that reduction in debt payments is due to the decline in mortgage rates so it’s not necessarily permanent—although the Federal Reserve has promised to keep the interest rates it controls at currently extraordinarily low levels until the end of 2014.

But the U.S. consumer is a global leader in deleveraging. The U.S. government hasn't begun to cut its debt. Spanish banks are just starting to write down the value of their real estate portfolios. In Brazil 22% of household income goes to debt service and the consumer default rate on loans and credit card debt hit a 30-month high in May. In China local governments are buried under a mountain of debt they took on, usually through government-affiliated entities, to back real estate and infrastructure projects that now can’t meet their interest payments.

Global deleveraging won’t necessarily result in global disaster—Brazilian consumers, for example, will eventually feel the effect of interest rate cuts that total 4.5 percentage points with the latest July 12 rate reduction—but it almost certainly means slower growth than usual after a downturn and lots of volatility in financial markets as deleveraging proceeds. I think it’s reasonable to expect that 2013 will be another year of disappointing growth and volatility-inducing uncertainty as governments continue to cut budgets and raise taxes.

So any strategy for a “bad market” and any attempt to identify good stocks for a bad market needs to consider the strong possibility that current enhanced volatility will be with us well into next year and that growth rates will be disappointingly low for that period as well.

What does it mean for a good stocks for a bad market strategy that the bad market could well go on for quite a while?

  1. Sitting on the sidelines in cash starts to become a very expensive strategy. Can you afford to earn close to nothing for another 18 months?

  2. The return on the 10-year Treasury bond becomes the benchmark to beat. That bond yields 1.56% now. If the euro debt crisis keeps pushing down U.S. yields, which pushes up U.S. bond prices, then the total return on Treasuries will be much higher. A drop in the yield for new 10-year bonds to 1.4%, certainly within the realm of possibility for 2013, would produce a gain of $85.71 in the value of a current $1,000 10-year bond. Add that to the payout from the 1.56% yield on the 10-year bond that you own and the benchmark becomes a total return of 10.1%. Unless it stands a reasonable chance of beating that benchmark, a stock isn’t in the running.

  3. Remember that as tough as it is to call the turns in a stock market, bondholders are increasingly looking at the need to call the turn in the bond market. At some point, inflation or higher growth or an end to the euro debt crisis will put an end to the downward path of yields and the upper path of prices for U.S. Treasuries.

  4. If you expect to beat that 10% Treasury benchmark potential return in a stock, dividend yields help. If yields on Treasuries continue to fall and prices to climb, investors can expect the yields and prices on other income vehicles to follow the same trends. You can’t depend on the price of Treasuries and other income vehicles to be perfectly correlated since Treasuries get a boost from buyers seeking safety that vehicles such as even blue chip stocks can’t offer to the same degree. But dividend-paying stocks will get the benefit of any downward trend in Treasury yields. It’s not an accident, for example, that Abbott Laboratories (ABT) with its 3.06% yield is up 6.4% in the last three months when the return on the iShares Barclay 7-10 Year Treasury ETF (IEF) is 3.9%. (Abbott Laboratories is a member of my Jubak’s Picks portfolio http://jubakpicks.com/ .)  Following this logic further, I added Bristol-Myers Squibb (BMY) with its 4.2% yield to that portfolio on weakness on Friday, August 3 http://jubakpicks.com/2012/08/03/pick-up-4-yield-and-decent-potential-appreciation-by-buying-bristol-myers-squibb-on-yesterdays-drop/ (I’ll have more picks in this category on Friday.)

  5. If you expect to beat that Treasury potential yield, use market volatility to make profits on short- and medium term swings in share prices. I gave you four strategies to use to profit from volatility in my July 31 post http://jubakpicks.com/2012/07/31/volatility-is-here-to-stay-and-you-shouldnt-simply-ignore-it-and-hope-that-it-will-go-away-here-are-four-investing-strategies-for-coping-maybe-even-profiting-with-it/ . I think it’s too early for some of these strategies—the strong half of the stock market year doesn’t kick in until November, for example—but I’d certainly be looking to use what is shaping up as a volatile August for a profitable swing trade or so. Of the stocks in my Jubak’s Picks portfolio http://jubakpicks.com/ I’ve been using shares of Gerdau (GGB) and Banco Bilbao Vizcaya (BBVA) in swing trades lately. I think last week’s rally has pushed them near to sells on this time frame—with the idea that you’d rebuy on the next downward move.

  6. There are a few stocks in this market that fit the traditional buy good stocks in a bad market formula because they seem able to go up even when the market doesn’t—or are at least able to hold their ground when the market stumbles. Stocks that come to mind are Apple (AAPL) and Precision Castparts (PCP), both in my Jubak’s Picks portfolio http://jubakpicks.com/ . (I’ll have a few more suggestions in this category in my August 10 post.)

  7. And finally there are a few stocks that fit the other traditional buy good stocks in a bad market formula because they’ve been hammered down in price, are exceptionally well-run and well-positioned companies, and—this is very, very important in a slow deleveraging recovery—show a history of bouncing back very quickly and very strongly ahead of the general market. I’d put Cummins (CMI) in this category. (Cummins is a member of my Jubak’s Picks portfolio http://jubakpicks.com/ ) (I’ll have a few more suggestions in this category in my Friday post.)

  8. And, unfortunately, it means that the traditional buy great companies in a bad market strategy isn’t likely to beat the Treasury benchmark—yet. If we’re in for a lot of volatility in the 18 months ahead and a sub-par period of economic growth, some of the stocks that you’d most like to buy at recent low prices aren’t likely to rebound quickly enough to beat my benchmark. In this category I’d put stocks such as Corning (GLW) and Nucor (NUE), both on my watch list http://jubakpicks.com/ and Coach (COH). I still think these are good stocks but it is simply too soon in this global economy to buy these shares.

Look for some stocks to fill out these strategies in my Friday, August 10, post.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple, Banco Bilbao Vizcaya, Cummins, and Precision Castparts as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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