Everyone remembers their first market crash.
Mine was October 19, 1987, when the Dow fell 508 points (22.6%) in one day.
This, of course, was before we all had computers on our desks (and in our pockets) to keep us up to date on what was happening. All we had were telephones—and unanswered questions about how some poorly understood computer-trading programs had allowed this to happen.
Happily, Cabot readers were prepared! The previous issue of Cabot Market Letter (our only advisory back then) was titled, “Remain in Your Storm Cellar!” and advised that readers hold at least 50% of their accounts in cash.
Back then, the reasons for that cautious view were threefold. First, our interest rate-sensitive indicator had been telling us since April that rising rates were bad for the market. Second, our new highs-new lows indicator signaled growing selling pressures. And third, the market’s advance-decline line looked terrible.
So our readers came through the crash in far better shape than many investors. And less than a month later we were issuing a new buy signal, as conditions had improved on many fronts.
Since then, I’ve been through many corrections and crashes, and with every one, I think I’ve learned a little more. Every one is different, but overall, there are many similarities, and the following are my main thoughts on them.
Crashes, Corrections and Bear Markets
1. Don’t get caught up in labels. Correction or crash or bear market, the only thing that matters to you is what happens in your own portfolio.
2. Don’t worry about what everyone else is worrying about; that’s already been discounted by the market. This year, everyone has been aware of the “fact” that rising interest rates will be bad for the market, and for many months, pundits have been speculating about when the Fed will raise rates—but all that speculation had no value at all to investors.
3. Trouble tends to come from where it’s least expected. In 1987, it was the computer programs; this year it was China.
4. Just as a bouncing ball experiences progressively smaller fluctuations, so will the market generally experience progressively reduced volatility in the days after a high-volatility crash. Some high-risk investors (particularly hedge funds in the U.S.) and some inexperienced investors (particularly newbies in China) have been crippled—financially and/or psychologically from the recent carnage—and will disappear from the market for a very long time, leaving slightly wiser survivors to carry on.
5. You will read a lot about how the government will fix the problem.
6. But for quite some time—quite likely through year-end—the actions of people selling losers will depress many stocks.
7. At some point, bargain-hunters will take control.
8. At that point, anyone still worrying about the conditions that caused the latest troubles will be left behind by a new bull market.
9. The key to success, as always, lies not in predicting what will happen but in tuning out the noise, focusing on what matters (the action of key indicators and the action of your own stocks), and using a proven system of investing such as you’ll find in all Cabot advisories.
What I See Today
Short-term, the sellers are in control of the market. Whether they’re expert value investors like Cabot’s own Roy Ward who are selling overvalued stocks, or crippled hedge funds trying to get liquid again or amateur Chinese investors swearing off stocks and going back to real estate, the main pressure on the market remains to the downside, as it has been since May.
And that’s totally normal, given that it was preceded by a six-year bull market!
So my simplest advice is to simply watch the market, and stay defensive until the buyers take control again.
And when might that be?
Well, predicting is very difficult, but my most valuable rule of thumb is this: the consensus is likely to be wrong.
Think back to 2009, when the world was reeling from the economic implosion. Did anyone predict a six-year bull market that would see the S&P 500 double in value and the Nasdaq quadruple? No one—although I did write the following, back at the end of March, 2009:
“Today the market gave us a huge rally, ostensibly because of Treasury Secretary Tim Geithner’s plan to remove hundreds of billions of dollars of toxic debt from bank balance sheets. To me, the reason for the market’s strength is unimportant. To me, what’s important are the charts. With this advance, we now have seven consecutive days in which the number of stocks hitting new lows on the NYSE has been fewer than 40. We also have numerous major indexes whose intermediate-term trends are poised to turn from negative to positive. Coming off a bottom that’s brought the lowest consumer confidence numbers in history, this uptrend has the potential to be a big one … precisely because no one expects it.
Let’s face it; nobody is greedy today. People are worried about the safety of their banks! And to me that spells opportunity.”
Readers who bought back then, and who’ve followed our generally bullish advice in the six years since then, have done well.
But today fear is nowhere near the level it was back then. Today the U.S. economy is generally fine, and the market’s recent troubles—so far—are being blamed on the Chinese market.
But I think that attitude is likely to change in the weeks and months ahead, as the economic repercussions from the Chinese meltdown work their way across the Pacific, and Americans gradually learn about all the areas of our economy that aren’t as healthy as we believe. I also believe, as I’ve been saying all along, that the Fed will continue to refrain from raising rates, simply because too many people have been expecting it, and there are too many global forces that are keeping rates low (and even negative in some places).
Of course, I could be wrong. Institutions could ramp up buying at these low prices and take old favorites like Netflix (NFLX) and Google (GOOGL) and Apple (AAPL) right back to their old highs in a matter of weeks.
If they do, we’ll jump right back into the market just as we did back in November 1987.
But the more likely scenario is that the malaise spreads, expectations are scaled back, and investor bullishness fades. And traditionally, such changes take time.
In any case, the key to success is simple. Keep an eye on the market. Stay on the right side of the market. Maintain an ever-changing watch list of stocks that are acting well and that have good growth prospects. And above all, cultivate the stocks in your own portfolio, nurturing those that are behaving well and kicking out those that aren’t doing what you hired them to do.
As for new buying, growth investors have a real challenge here. Most charts have been bent, if not broken, and until the market can heal some of those charts and give an indication of who the new leaders will be, it’s wise to go slowly.
Value investors, on the other hand, suddenly have numerous opportunities to pick up good, high-quality companies cheap!
In my mind, there are two ways to do this, and I’m going to present both here.
Strategy One is to buy a quality undervalued stock that’s just pulled back to a decent support level, like Cognizant Technology Solutions (CTSH).
Cognizant, in business since 1996, provides technology consulting and outsourcing services to a wide range of companies in financial services, healthcare, manufacturing, retail, and more. With revenues of $11.3 billion in the past year, it grows revenues and earnings every year by double-digit rates. It pays no dividend. And it’s now trading at a reasonable PE ratio of 21.
Here’s the chart, which shows that CTSH has recently pulled back from nearly 70 to the 60 level, where it has support dating all the way back to February. It’s now 12% off its high.
Strategy Two is to target a stock that’s gone of the rails, that’s been thrown to the dogs, like Schlumberger (SLB).
Schlumberger, in business since 1926, is one of the leading oil service companies in the U.S. With revenues of $44.6 billion in the past year, it’s had single-digit revenue growth in recent years, and the past two quarters have actually seen earnings shrink, as the pressure of falling oil prices has worked back to Schlumberger. But the company pays a dividend of 2.8%. And its current PE ratio is a lowly 15.
Here’s the chart, which reveals that investors in SLB have been abandoning ship in recent days. It’s now 42% off its high. No one likes oil stocks. And even the announcement yesterday that Schlumberger would spend $14.8 billion to acquire competitor Cameron (CAM) brought little buying.
If you’re in a gambling mood, you could jump into SLB here; it’s got to bottom somewhere. Or if you’re a bit less adventurous, you could buy some CTSH. Odds look good.
But what I really recommend is that you become a regular reader of Cabot Benjamin Graham Value Investor, where every month, Roy Ward, Cabot’s value expert, provides a complete overview of the market along with assessments of the top 275 value stocks.
Both Cognizant and Schlumberger are on this list, and Roy has specific Maximum Buy Prices for each one of them, prices that ensure that you don’t overpay for either of these stocks.
Roy’s system, which he’s been refining for 51 years, is rock-solid.
Over the 12 years the Roy has been with Cabot, his portfolio is up 250%, compared to increases of 98% for the Dow and 123% for the S&P 500.
If your portfolio’s performance in recent months has been unsatisfying, Roy’s sensible, time-tested system may be exactly what you need.
Yours in pursuit of wisdom and wealth,
Chief Analyst, Cabot Stock of the Month
Publisher, Cabot Wealth Advisory