Ideas on dealing with bear market uncertainty
It has taken nine months, but the UK stock market has now completed its long, slow grind into official bear market territory. From a peak last April, the FTSE 100 is down around 22%. The shocks started last August when the main index fell by more than 9% in a week. Valuations drifted after that, and the first six weeks of 2016 have been pretty painful to watch. Unlike the the sudden sell-off you might see after a black swan event, this decline has been slower to unfold, but the downward trend is so far inescapable. Rather than one knockout punch, investors have been forced to take tiring jabs on a regular basis.
Faced with this sort of chart - the FTSE All Share (below) - and the clear slide into correction mode, it’s obvious to wonder about the best course of action. In recent days we’ve seen a lot of discussion about how to handle these conditions. So here are some ideas to consider from previous experiences of stock market declines and shares that appear to be in freefall.
1. Falling prices can be desirable
It might sound counter-intuitive, but for investors with a long, potentially multi-decade investment horizon, falling prices - while scary - are useful. Whether you choose to sit tight or sell positions and hold cash, a falling market will inevitably offer opportunities to buy shares at cheaper prices. This is the classic Warren Buffett mindset.
In his 1997 letter to Berkshire Hathaway shareholders, Buffett offered this short quiz:
“If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?”
While the answers are obvious, he insisted that investors don’t always see the stock market the same way:
“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense."
Buffett’s point was that only those selling shares in the near future should be happy to see markets rise, while everyone else should be happy to see prices lower.
For those faced with the prospect of seeing their portfolios battered by a falling market, it might be worth considering another of Buffett’s one-liners: “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.”
2. Man overboard!
What do you do if one of your stocks falls by 10% or more in one day? The slow-burning nature of this market correction means there haven’t been many double-digit one-day fallers. But there have been some very sharp individual pull-backs. Take Pendragon, the auto dealer, which has seen its price fall by 25% in 2016, and more than 12% in February - on no news.
This type of move can cause emotional turmoil in some investors. In The Little Book of Behavioral Investing, James Montier points out that people generally hate losses somewhere between two and two-and-a-half times more than they enjoy equivalent gains. As such, there’s a risk that the financially damaging effects of loss aversion and the disposition effect (a preference for selling winners and holding losers) can set in.
One way to counter this problem is to apply a checklist approach to a falling stock. We’ve mentioned it before, but this is the territory of Michael Mauboussin, the Head of Global Financial Strategies at Credit Suisse. In a paper called Managing the Man Overboard Moment, Mauboussin uses four key factors which he breaks down further using some proprietary scoring. The essence of the checklist is straightforward and maps very well to Stockopedia’s StockRanks:
- Earnings or non-earnings - did a financial news update cause the price fall?
- Momentum - are earnings and price momentum positive or negative?
- Valuation - is the stock price cheap or expensive against fundamentals?
- Quality - is this a good quality stock or not?
The research shows that some combinations of these factors can be helpful in deciding whether to buy or sell the stock:
Buy Signals - There is a strong case for buying stocks that had weak momentum prior to the price fall, particularly if they are both cheaply priced and high quality.
Sell Signals - The research found that when prices fell on earnings news, momentum alone doesn’t give a strong buy or sell pattern. However, the strongest sell signal was found in high momentum, expensively priced shares.
For Stockopedia users the signals that Mauboussin identifies may be familiar. Our taxonomy of StockRank winners and losers isolates ranking strengths and weaknesses, which could help guide trading trading decisions. You can read more about that here.
3. Portfolio health check
How strong are your stocks? At Stockopedia, we rank every company in the market according to how well it scores against a range of measures that fit onto the three categories of Quality, Value and Momentum. Historically, portfolios of shares that rank well against these factors have tended to outperform. You can see how this portfolio approach works by reading up on how Ed built the New Year Naps.
While all the rank deciles have been hit during by the rocky market conditions, the highest 10% - with a StockRank of 90+ - have held up, and not slumped as badly as the market. Since the market top, the top decile StockRank portfolio is only down around 12%. But since we started tracking the StockRanks in April 2013, the top decile up by more than 60% against the All-Share index that’s down by around 8%.
Since 2013, portfolios of shares in the bottom 30% of the market have consistently underperformed the FTSE All Share. Shares with a StockRank of less than 10 out of 100 have slumped to a negative 56% loss. These are shares that are expensive, poor quality and with failing price and earnings momentum.
Typically, the very lowest ranking stocks tend to be speculative, small-cap companies that are often unprofitable and have unproven businesses. This is also the territory of shares on overstretched valuation that are particularly susceptible in falling markets. These can still be popular among some investors, and while some will do well, this is a statistically low performing part of the market.
Keep calm…
There was a fabulous anecdote told by James O’Shaughnessy a couple of years back about a study by Fidelity that found the best performing portfolios were held by people who’d forgotten about them, or who were… dead. While there are many moving parts to this subject - and capital preservation is a very high priority for most of us - it’s worth considering whether no action might be the best action. Selling down portfolio positions with a plan to buy them back later will certainly free up cash and make it easier to sleep at night. But it takes an awful lot of discipline. Deciding when to buy them back could get very stressful. And that’s on top of all the round-trip costs and missed dividends that might be incurred.
In the past few years I’ve not had to write that many articles on dealing with down markets - or even consider the consequences for my own portfolio, beyond the occasional dip. So it would be great to hear how others approach this. Is doing nothing really the best approach?
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27 comments
This is my personal approach.
If you have some speculative stocks in your portfolio, and have held these for a while, then a bear market is the time to dispose of them, if they haven't come good in a bull market they almost certainly won't in a bear market, the only potential exception is if new news is around the corner.
Regarding Stop Losses, I only use them on leveraged products (mainly CFD's and the odd Spread Bet), the reason is they can be guaranteed and as such I won’t suffer from overnight gapping, the implications of not guaranteeing your stops can be very expensive when you carry up to a 20x multiple on each position. I do not put stop losses on my share holdings. however I do have a mental stop loss on each, the reason for this is that you lose control with automatic stop losses, and you could end up losing your position due to an over-reactive market gapping overnight, and worse you could end up selling at significant losses which you may consider to be unjustified. Better to check your positions regularly and make your own judgement call.
So in summary I generally hold through a bear market with the exception of disposing of speculative stocks or if a particular company posts some bad news.
I do not buy a stock if it is falling sharply, in either a bear or wider bull market, I learnt this the hard way, catching a falling knife has rarely worked out for me. What I do is watch stocks that interest me from a fundamental perspective and monitor them. I then use technical indicators to help me determine when a more positive momentum is likely to occur. Yes you will lose some of the % gain but for me it provides a safer investment, technical indicators I find help me with the emotion of entering positions. Bear markets are great for this sort of investment strategy as even if the stocks move lower, you have at least bought cheap, and you are happy with the fundamentals.
For me, the interesting challenge is how much of my remaining cash to spend and when to spend it.
On average, there is approximately a 15% fall in the market during any year (See JPM Guide To The Markets -an excellent read, by the way). So in a typical year, when there is a fall of that level, it could be a good time to deploy a good proportion of that year's investment. Particularly for people following indexs. If stockpicking, it's not quite as easy, as the stocks on your watchlist might not be at an attractive valuation.
The other question is if into a proper bear market, how much of a market fall should I wait for before being approximately 100% invested ?
In practice, as I'm no George Soros, I have a target average monthly investment and look to exceed that average when markets are down.
Many thanks UK Value Investor and pka - so I think I'll steer clear of shorting ETFs for now then! As far as Hedging then I'm going to try to be a: fully diversified and b: keep some cash to buy in again on the new lows. I really appreciate the input!
Two quotes from Ben Hobson's post 'For investors with a long, potentially multi-decade investment horizon, falling prices - while scary - are useful' and 'the best performing portfolios were held by people who’d forgotten about them, or who were… dead' rather sum up the problem. As a 60 year old I don't have a multi decade horizon ( maybe 2.5!) and my portfolio is no use to me when I'm dead!! However, agree that when panic is all about you it is important to keep your head. It is unfortunate that some of my recent investments have been badly mistimed - March 2015 for FTSE 100 high yield strategy, Japan & Europe also in 2015 in line with consensus 'expert view' (though as Goldman Sachs e.g. already backtracked on Jan 2016 generic 'buys' such views worthless!). Nevertheless not sold anything apart from Avon Rubber (LON:AVON) which hopefully met Mauboussin's rules though inevitably went up 5% + the moment I sold!
In response to sealyed on New Year NAPs I implemented this strategy at start of January 2016 Portfolio of 20 stocks is currently down 7.3% vs the FTSE all share index fall of 6.7% - not startling but not disastrous. Some of stocks are flirting with stop loss though so not all good! Be interesting to see how develops during 2016.
I've been using Stockopedia for about a year and a bit for my SIPP and have tried to focus more on a mechanical approach. Stocko's tools are superb and as I am no Paul Scott. It would take me about a day to try and understand a balance sheet, and even then I would probably miss some pension deficit.
My portfolio is about 25 stocks, two or three in each sector, all high Stockranks, that I will try and turnover yearly but may try quarterly this year. It performed well last year, up about 33%. What to do in a bear market is what is taking up my thoughts this year. Thanks for the article Ben. And thanks Grindertrader on useful commentary on your methods! Good to read other investors thoughts.
My general approach anyway is to set up stop losses on all my shares around 10-13% and just let the computer decide when to sell. I had trailing stops on my winners (the ones 60%-100% up). This bumpy year alone I would say I have been stopped out of about 10 shares. My other 15 remain, with a couple getting close to stop positions so I am expecting to get stopped out on a couple more if the bear gets worse. So, worst case scenario is I get stopped out on all my shares (big winners, medium winners and small losers) and hopefully my loss is minimised, with my 33% gain reduced to 20-25% (i've not done the math on that).
I am now in cash about 30%, I bought XUKS to hedge, but only 5% of my portfolio, so probably won't make a huge amount off that, but wanted to try it. Shorting individual stocks I have not tried yet and probably won't as I'm still trying to get the hang of this mechanical way of 'standard' investing. And i haven't looked at spread betting yet as I don't have the risk appetite.
When to buy back? I don't know. I think I read Ed Croft mention a guru technique of waiting a year when a bull market kicks in, so may try that. I have about a 25 years till retirement so maybe doing the buffet thing of buying and holding through thick and thin would be best and I am making a big mistake. I know I can't time the market but I sleep better knowing I am preserving capital during market turmoil. And as Robbie Burns says - you can always buy back lower.
All the best all!
Bear Markets are good in my opinion . I am of the view that the bear market is a positive healthy and natural occurring event that must happen. The bear market will punish the valuations that have gone far too high and also clear out some of the speculative stocks that lay in my view at the bottom of the markets especially AIM and do not deserve to be listed.
Bear markets force me to look even harder into all my investments. I have to be more critical in my own approaches to investing and clear out any holdings that give me doubts. I am forced to question myself further, while my false confidence is taking a battering.
My ISA is 'only' down 10% during the last 3 months but still up. Why ? Well I had been stopped out and looking at some of the stocks that were stopped out I see they are still falling.
The checklist approach is important for me. I am not interested in speculative, recovery or stocks with profits warnings on my long term view. So if profits, earnings and revenue are not going to increase, debt increases then there is no chance in a bear market i would buy in. On the stocks that remain they must still pass all my checks and also price momentum upward must stay strong.
The bear market has left me with only a few stocks now. I am now 70% cash waiting for the right time to take advantage.
So what of the trying to find the bottom? I shall not even try to figure out where the bottoms is. But I will know when the tide turns simply with my checklist rules. I have quite a bit of cash now and when the time comes I will find as more and more stocks, discounted by the bear market start to appear on my checklist. I will not find the very bottom but can be assured it will be pretty close from it. For this point when we approach a bull market again I will be 100% invested again and sure to enjoy the ride up.
My problem with Buy and Hold Strategy Doing nothing and holding through thick and thin may be a the best long term strategy, I do not know. But my psycological weakness is that I MUST do something. I have the urge to tinker now and again. My small separate trading accounts help my gambler instincts , which indeed stops me from tinkering too much with my long term holdings. However i am only human so unless I am sent to a desert island with a crate of the finest malt whisky and no internet for the next year or so, then my strategy should work for me.
best wishes
Ian
Hi Ian
Thanks for a very informative and helpful post. Can you please explain a little more about when your checklist tells you to buy back in? How is it related to the QVM StockRank scores specifically?
Many thanks!
I'm quite new to this game and suspect I am in the process of making the kind of beginner's trading mistakes that the more experienced users above have been through a while ago.
My portfolio is down about %20 since April last year which equates to a 10k loss and that's causing some anxiety! All of them were bought before Stockopedia membership and I'm considering trading most of them out for high StockRank stocks and just sitting tight. I'm definitely a long-term investor. I am also aware I am over exposed to US technology stocks (Apple, Google, FB) and I'm considering hedging against further losses here. I don't know much about short selling but I've seen some ETFs that short the market and specifically one that shorts US technologies. Could you please tell me, in your view, if these kinds of ETFs are a sensible way of hedging and if not what hedging methods work best for you?
Many thanks!
Hi BillyChapel,
Here is an article on another website about short ETFs - the author doesn't like them:
http://monevator.com/short-etf-maths/
My approach to hedging is to just be very diversified. Although I'm invested almost 100% in equities I make sure the portfolio is spread across at least 30 companies, at least 10 sectors (both cyclical and defensive) and with lots of geographic diversity as well.
Thanks UK Value - out of interest - which Geographic areas are you liking atm? Or just an even split between Europe, the US and the UK?
I just divide it between UK and international, measured by revenues (or profits if I can't get hold of revenue data). I want UK revenue to average less than 50% across all the stocks in my portfolio. For the international portion I'm not to fussed as it tends to be spread all over the place without having to think about it too much.
I also don't like or dislike any particular area, although companies that I have been buying into lately have had an emerging market focus as those companies are getting cheaper at the moment for obvious reasons.
Hi BillyChapel
Short ETFs are only really suitable for day traders who close out their positions at the end of each day. Although it is counter intuitive, unless the underlying index or equity of the short ETFs falls in a straight line, with no up days (and, in practice this never happens) then even if the underlying index or equity falls over time, you are virtually certain to make a loss. Avoid like the plague! Large positions in leveraged short ETFs - absolute disaster beckons!!
David Talbot
Tough times mean taking tough actions. On the above example of Pendragon, a stop loss should have saved most of the 30% drop in the last month or so. I cannot see the logic in not exiting the position to get a small dividend in the future.
I can see that companies that consistently pay decent dividends is a different kettle of fish and then the magic of compound interest comes into play.
Fishing in the "right pond" also makes a huge difference. I did a small survey last night comparing bank stocks, which have been taking a hammering over the last year and mining stocks. Lloyds today traded 152M shares after drastic recent falls,for example, and my local branch has notified me of closure.More drastic action which should help get better profits for Lloyds and a few more people out of work no doubt.
Mining stocks however have done much better in the last month or so, mainly in gold & silver.
A selection of 14 stocks showed an average return of over 7% for yesterday. Possibly the low oil price helps the running costs of the heavy machines required to excavate the land.
Here is the list,............HOC, RRS, ACA, HGM,CEY, GDP, TSG, FRES, CMCL, MAR, EUA, SRB, OMI, STI.
One of these 14 stocks has a stock rating of 100. Consider checking them out.
My 2 Stockopedia screens help in sorting the wood from the trees.
First screen shows a minimum of 30% in a month and are 30 in number showing 33% to 110%
Second screen shows at least 100% in a year and are 48 in number.
These two screens are backed up with checking the 50 Day MA and stop prices.
This year I have decided to top slice at least 10% of profits in stead of waiting to collect a dividend, a sort of DIY dividend which seems to be working OK currently.
ETFS are useful tools to use too.
"Don't just do something, sit there!" is perhaps the best advice I've heard.
Generally I would say:
So bear market's are almost never a bad thing, but investors make them bad by selling at the bottom. Not that I blame them because that's exactly what I did at the bottom of the bear market in 2003 when I had no idea what I was doing.
Unfortunately it is in most people's nature to sell at precisely the wrong time and for many investors making mistakes in a bear market is a necessary part of the learning process.
Nice article and good case study with PDG, it is a company I personally hold and you can see from the graph how volatile it has been. I keep expecting some negative news, but nothing. The last August statement was extremely positive as well. Results are next weeks, so it will be very interesting if anything negative comes out to justify the 30% + drop
Hi Ben,
Really good article, thanks. The message is nothing really new for Stocko subscribers, but it's very helpful to read an article like this at the moment.
For my part, I've not sold anything - my holdings before the slump kicked in were fairly cheaply valued, decent quality with positive recent results/updates, with good dividends for the most part.
I've bought a couple of shares recently as well, again fairly lowly value and/or good quality, with good dividend yields.
That is the main thing I am enjoying in this market now I think about it, getting some good quality 4-6% dividend yields.
Ta
Chris
Hi Chris,
Thanks! I totally agree about the yields, that's definitely along my line of thinking. On a related point, my mother recently gave me some money to invest for my two young kids. Talk about sharpening the senses! But in a falling market, where you see the yields improving, it does give a bit of comfort, I'd definitely go along with that (plus, it's a bit easier to explain to an 8 year old that the company is paying him for holding it - he likes that idea!).
Cheers!
Thanks Ben.
This is what I love to see:
How to take the emotion out of decision making.
How to make complicated decisions more straight forward.
How to make decisions based on academic evidence.
Great stuff! I have made a little spread sheet around it to make it even easier.
Can you share the spreadhseet Warranstar?
Regards,
Source.
HI Source
I'm willing to share it. But I can't see how to do it. Any suggestions?
Hi Warranstar - here is my email for you to use and send it to:-
baron8888_2000@yahoo.com
Thanks!
My approach during the present bear market has been to reduce the proportion of my portfolio that is directly in equities from 60% to 50%, and to increase the percentage in multi-asset funds and targeted absolute return funds from 40% to 50%. I've also switched out of any equity funds that have fallen significantly over the last 6 months, such as funds invested in China and biotechnology. Time will tell whether this is a sensible strategy, but it helps me sleep better at night!
If you hold solid companies sit tight they all come back in time and more. As a retired car dealer Pendragon borrowed a lot of money to buy small dealerships so that they could become a national company, then 2008 hit, they nearly went under. They are still carrying big borrowings. With all the media and experts shouting 'recession, recession' and should a recession occur their stock value will decimate. So I assume investors are panicking in case there is a recession, however as far as I am concerned I think the ordinary persons feels better off at the moment due to low interest, and cheaper food and fuel.
Hi mortimer, that's an interesting point about Pendragon. I think I'm with you, I can't really see this being a turning point for car retailers. I'm kind of in the market for a car at the moment (I procrastinate about these things a lot) and I took mine for a service recently - a place owned by Vertu Motors (LON:VTU) - and the service car park was much busier than I've ever seen it. Separately, as quite a heavy user of the M40, the number of new cars on the road... well, I can't see the market for aftersales falling too far in the coming years (although I'm no expert on all the mechanics of the sector, as it were!)
Cheers!
Hi Ben
The only part of after sales that has fallen are the spare parts. Car do not go wrong as much as they used to they are more reliable. Everything from bulbs to exhausts last so much longer. I agree with you, whilst people feel more relaxed about the economy then they buy new cars regularly but that changes when they perceive things going wrong again which then has a knock on effect on the values of all car stocks they hold. The main months to buy a car to get the best deal are either August or December. These are the two months that dealers are at their quietest and more open to an offer.
Great thoughts Ben.
How are the New Years Naps doing compared to the market?
Be good to also see an analysis of high stock ranks vs low stock ranks since the market peak.