Picking Stocks for a 'Bad' Market

08/07/2012 9:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Buying good stocks in a bad market is a time-tested strategy. But this nagging mess isn't your typical rough patch, so choosing the right ones is more complex, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

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—Apple (AAPL), for instance—that go up 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 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—all of which can claim the title, "Buy good stocks in bad markets.”

So let me try to pick apart those assumptions and definitions so we can distinguish the different flavors of "Buy good stocks in bad markets." I think this exercise will lead us to a couple of strategies that you can mix and match as the market continues to evolve. In my next column, I'll flesh out these strategies with some specific stock examples.

Defining This 'Bad' Market
Let's start with the question of exactly why we call this a bad market.

If you look only at the market's gain year 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 S&P 500 was ahead 10.6%.

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.

But if you went back 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 1,419, back on April 2, in a belief that the rallying market would continue, you'd have still been underwater at the August 3 close of 1,390.99. 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.

Why 2012 Feels So Bad
First, we look back and say this is a bad market because of the unnerving—and potentially costly—volatility in stocks.

Yes, the swings to the upside of the past two months—an 8.8% gain for the S&P 500 from June 4 through August 3—and of the past week—a 4% gain from July 25 through August 3—are great. But you also get 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—with 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%). The year ended with a lackluster net gain of 2.12%.

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.

The Macro Mess
Here, we're projecting based on our read of global macroeconomic trends. If you:

  • believe that the Eurozone countries haven't fixed the Euro debt crisis, and that those economies will slide further toward recession in the next 12 months
  • 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
  • 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 high of 1,419 anytime 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.

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.

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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 less frequently, and sometimes even 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 even 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 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?

When It's Long as Well as Bad
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 by the meltdown in the US mortgage market.

In 2006, US housing prices abruptly went into reverse, falling 3.3% from the fourth quarter of 2005 and 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 deleveraging demanded by a financial crisis like this means investors aren't looking at anything like the traditional V-shaped bust and recovery.

US consumers have begun to deleverage (pay down debt). The total debt service paid by US 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 interest rates at currently extraordinarily low levels until the end of 2014.

But the US consumer is a global leader in deleveraging. The US 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 default rate on consumer 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) 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, must consider the strong possibility that current volatility will be with us well into next year, and that growth rates will be disappointingly low for that period as well.

What Stocks for This Bad Market?
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?

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

The return on the ten-year Treasury bond becomes the benchmark to beat. That bond yields 1.56% now. If the Euro debt crisis keeps pushing down US yields, which pushes up US bond prices, then the total return on Treasuries will be much higher.

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A drop in the yield for new ten-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 ten-year bond. Add that to the payout from the 1.56% yield on the ten-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.

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, too. 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 to the upward path of prices for US Treasuries.

If you hope to beat that 10% Treasury benchmark potential return with a stock, dividend yields help. If yields on Treasuries continue to fall and prices 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 other vehicles—even blue-chip stocks—can't match. But dividend-paying stocks will get the benefit of any downward trend in Treasury yields.

It's no accident, for example, that Abbott Laboratories (ABT), with its 3.06% yield, is up 6.4% in the past three months, when the return on the iShares Barclays 7-10 Year Treasury ETF (IEF) is 3.9%. (Abbott Laboratories is a member of my Jubak's Picks portfolio.)

Following this logic further, I added Bristol-Myers Squibb (BMY), with its 4.2% yield, to that portfolio on weakness on Friday, August 3. I'll have more picks in this category in my next column.

If you expect to beat that potential Treasury 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 30 column, 4 Ways to Win in a Wild Market.

I think it's too early for some of these strategies—the strongest six months for the stock market 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, I've been using shares of Gerdau (GGB) and Banco Bilbao Vizcaya (BBVA) in swing trades lately, buying on short-term swings down and selling when they move back up. I think last week's rally has pushed them near to sells on this time frame—with the idea of rebuying on the next downward move.

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 at least able to hold their ground when the market stumbles.

Stocks that come to mind are Apple and Precision Castparts (PCP), both in my Jubak's Picks portfolio. (I'll have a few more suggestions in this category in my next column.)

And, there are a few stocks that fit the other traditional "buy good stocks in a bad market" formula because they've been hammered in price, are exceptionally well-run and well-positioned companies, and—this is very, very important in a slowly deleveraging recovery—show a history of bouncing back quickly and strongly ahead of the general market.

I'd put Cummins (CMI) in this category. (Cummins is another member of my Jubak's Picks portfolio.) I'll have a few more suggestions in this category in my next column.

Unfortunately, the traditional "buy great companies in a bad market" strategy isn't likely to beat the potential Treasury benchmark—yet. If we're in for a lot of volatility in the next 18 months, along with subpar economic growth, some of the stocks 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), which are both on my watch list, and also 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 next column.

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, 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 here.

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