8/6/2012 8:01 PM ET|
Picking stocks for a 'bad' market
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.
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 Aug. 3 -- calling this a bad market seems just plain wrong. For that period, the Standard & Poor's 500 stock index ($INX) 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 Aug. 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 Aug. 3 -- and of the past week -- a 4% gain from July 25 through Aug. 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 Aug. 10 (down 16.3%), and extraordinary surges, like that from Oct. 3 to Oct. 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, 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, and 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 high of 1,419 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 Dec. 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. 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 frequently 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?
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