Don't throw out the baby with the bath water.
The adage is useful in wide swaths of life. It has certainly helped me more than once in raising two children.
But as investing advice, it's often just plain wrong. The truth is that some of the time you would do well to throw out the baby with the bath water.
Take Spanish bank stocks. No doubt about it, you would have been better off getting rid of them all in your portfolio back when the euro debt crisis hit. For example, Banco Santander (STD), my favorite Spanish bank stock even now, sold in New York as an American depositary receipt for $16.56 on Jan. 15, 2010. At that time, you could have sold all Spanish bank stocks just when a new Greek government had revealed that the Greek budget deficit for 2009 was 12.7% instead of 3.7%, thanks to some deceptive accounting. You could have sold at $11.70 on Nov. 15, 2010. That month the European Union decided to bail out Ireland. On April 18, 2012, Banco Santander traded at $6.34.
Or take solar stocks. You would have been better off selling everything in that sector back in December 2011, when it became clear that all the cash-strapped governments of Europe -- and the Germans, too -- were going to cut solar subsidies in 2012. First Solar (FSLR), for example, sold for $47.99 a share on Dec. 7, 2011, but closed on April 18 at $21.36.
One more recent example: shares of natural gas producers. You would have been better off selling off the entire sector sometime after natural gas prices peaked in the summer of 2009. Shares of Chesapeake Energy (CHK) traded at $28.59 on Sept. 28, 2009. They closed at $18.06 on April 18.
By better off, I mean simply that in these instances an investor would have lost a lot less money by throwing out the baby with the bath water and selling everything rather than holding on in the belief that either the carnage would soon be over or that some stocks in the sector would manage to escape the general bloodletting.
Jim Jubak
Why don't we get this call right? Why, for example, am I sitting on shares of Banco Santander and solar cell producer Yingli Green Energy (YGE), for example, in my Dividend Income and Jubak's Picks portfolios, respectively?
Because sometimes it's hard to correctly identify the bath water. And because sometimes it's hard to know exactly how deep the bath water will get. And sometimes because we want to make sure that we'll be able to find the baby again.
Testing the bath water
Let's see if recent history can teach us anything about doing a better -- by which I mean more profitable -- job with those babies and that bath water. I think I've found five baby-and-bath-water rules worth considering for the next market crisis.
Let's start with the basic problem: Sometimes it's hard to see the tub filling, and it's almost always tough to know precisely where the water level will wind up.
Consider a more detailed visit to the chronology of the European debt crisis.
Knowing what we know now, it's easy to say that an investor should have tossed everything out the window in January 2010, when the extent of the Greek budget deficit deception became public. Remember, however, that in the summer of that year, eurozone leaders came up with a fix: the first Greek bailout package. It was hard then to see that this would be a crisis that consumed not just Greece but also Ireland, Portugal, Italy and Spain.
Maybe the time to toss the bath water came in November 2010, with the Irish bailout package. I think that was certainly a big warning sign, since the Irish crisis was essentially set off by a real-estate boom and bust in an otherwise globally competitive economy. It would not have been a big stretch then to think that this crisis could spread to Spain, which had a real-estate boom and bust that resembled Ireland's.
The market didn't conclude that. In the case of my Spanish benchmark for this crisis, the ADRs of Banco Santander, which plunged to $8.77 on June 7, 2010, had rebounded to $13.46 by Oct. 18. They would dip and then recover again, to $12.02 on Feb. 11, 2011.
Here are my first two baby-and-bath-water lessons:
Lesson No. 1: One way to tell if any seeming crisis is a real one that deserves chucking the baby out the window -- as opposed to a short-term panic where the sound strategy is to not only protect the baby but to buy shares -- is that the market will show repeated dips and recoveries. The crucial time in that cycle to be asking hard questions isn't the dip -- that's the time to fend off mindless panic. The hard-question time is at the recovery. And the question then is, "Has anything really been done to change the crisis?" If the answer is "no" -- and I think that would have been a reasonable conclusion to draw in November -- then the recovery isn't real and it's time to sell.
Lesson No. 2: Like bear markets, crises are punctuated by periods when the market swings toward unwarranted optimism. That means that even if you miss the first exit, you get other chances -- if you're not too stubborn to use them. The worst thing you can do is hold on because you are determined to get back to even. Suffering a loss as Banco Santander goes from $14 to $10.80 is painful. Holding on just because you want to get back to $14 only multiplies the pain.
A crisis is a time of extreme stock price volatility. Sure, the overall trend is downward in a crisis, but the rallies inside that downtrend can be rather spectacular. On Jan. 6, 2012, the ADR of Banco Santander traded at $6.91. But on what turned out to be false hopes that the 1 trillion euros in three-year loans from the European Central Bank had fixed the problem, the ADRs moved up to $8.76 by Feb. 9. That's a 26.8% gain in a month. Not bad for a rally in a downtrend. Of course, by April 13, the ADRs were back down to $6.40. Rallies don't last long in a crisis. When fear, rightly in this case, reasserts itself, the gains evaporate. But that leads me to my third baby-with-the-bath-water rule.
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