Six Housing Markets At Risk Of Another Correction

(Source: imgflip)

In a week that reminded many of the correction of early 2018, stocks (SPY), (DIA), (QQQ) saw huge volatility and large losses. The CNN Fear/Greed Index (made up of 7 short-term indicators) even fell to 5 on Thursday. That was its lowest level in over three years.

(Source: CNN)

On Wednesday and Thursday, the Dow fell about 1,400 points and the S&P 500 is facing the worst start to any October since 2008. In fact, the S&P 500 and Nasdaq are currently experiencing their worst starts to any month in seven years.

Such short-term drops can indeed be scary and cause many to fear that another correction (second of the year) or even bear market may be starting. But the time to panic-sell is never, despite what some sensationalistic headlines would have you believe. So here are three ways to not just protect your portfolio from potentially costly mistakes during market downturns, but that can actually harness market volatility to help achieve your long-term financial goals.

1. Stay Calm And Keep Things In Perspective

I'm an ardent fan of market history, which is why I always try to help readers keep things in perspective. That's in the short, medium, as well as long term. The right perspective can help you avoid making a costly mistake, like panic-selling during a market downturn.

In the short term, let's remember that while the financial media loves trumpeting headlines like "Dow Plunges 832 Points", such things are not nearly as scary as they appear.

(Source: Wikipedia)

Yes, Wednesday's "plunge" in the Dow was the third-largest single-day point decline in history. But remember that absolute declines are meaningless without the proper context. The Dow recently hit nearly 27,000, so you need to think in terms of percentages.

(Source: Wikipedia)

When we look at the biggest daily drops in terms of percentage, Wednesday's 3.2% "crash" doesn't even come close to making the top 20. In fact, in order for the Dow to crack that list, it would need to see a 1,820-point decline.

Next, let's consider the medium-term perspective. Despite the terrible week that all three indexes saw, they are still up for the year. Given last year's 20% rally, this year's market rise still means long-term investors are doing well.

Chart

SPY Total Return Price data by YCharts

What's more, stocks are still close to their all-time highs and not yet threatening a correction.

Chart

SPY data by YCharts

But what if we do get a second correction this year? Well, that also wouldn't necessarily be a bad thing.

In 2017, investors were spoiled by the smallest volatility in over half a century. The largest decline from all-time highs in the S&P 500 was just 3.4%. Even for investors who love to "buy the dip" (like me), there was literally no dip where to buy last year.

What about investors afraid of corrections? Well, this is where long-term perspective is essential. Since 1965, there have been 17 market corrections. On average, one happens every three years or so, but sometimes you can get two in a single year, as occurred in 2015.

Since 1965, the average correction (excluding the last one) has seen the S&P 500 fall for 87 days, decline a total of 12.4%, and then take 121 days (four months) to reach a new all-time high. The last correction saw the stock market bottom in 13 days, fall just 10%, and then take about four months (average) to fully recover. This means that the correction we saw in February, which many considered so traumatic, was one of the shortest and mildest in over 50 years.

(Source: Morningstar)

And lest we forget, corrections themselves are very short-term events. Investors need to think in terms of years, not months. Since 1926, on an annual basis, the stock market has finished positive 74% of the time. Over longer time frames, the probability of making money rises significantly, reaching 100% over 15 years. Not even those who bought at the market top in 1929 and then watched stocks crash 90% during the Great Depression lost money by 1944. And that's assuming they never invested another penny to dollar-cost average into the greatest buying opportunity in history.

The point is that the media loves to hype sharp market drops to attract attention and sell ads. By staying calm and keeping market declines in the proper historical context, you can make better long-term decisions about your portfolio.

Remember that it's precisely because the stock market is volatile that its long-term returns are so great. Since 1871, the S&P 500 (or its precursor) has generated 9.2% CAGR total returns (7% adjusted for inflation). This means that over the past 146, years buy and holding the S&P 500 would have doubled your real buying power every decade. That equates to a 19,756.15 fold increase in your wealth. But guess what? Had stocks moved steadily higher every single year (in a straight line) with no volatility, those returns would have been impossible. That's because investors would have bid up those "risk-free" stocks to insanely high valuations. Precisely because stocks are a "risk asset", subject to periods of immense volatility when they go on sale, are they worth owning in the first place.

This is why I try to remind readers to not fear volatility but to embrace it. Remember that bull markets make you money but bear markets make you rich.

2. Trust Your Long-Term Investment Strategy, Not Market Timing, To Protect Your Wealth

One of the most common types of articles I see online is some form of market timing piece in which an economist or analyst is attempting to determine when the market will correct next. While it's theoretically great to be able to avoid corrections (and bear markets) entirely, in reality no one can predict market tops or bottoms with any accuracy. And believe me, vast fortunes have been spent by Wall Street trying to do just that.

The stock market is by far the greatest wealth creation engine ever devised.

(Source: Credit Suisse)

Since 1900, stocks have generated 9.6% annualized total returns, which is 6.5% adjusted for inflation. That's far superior to bonds or cash equivalents. And over the past 20 years, stocks have similarly been one of best-performing asset classes, beating housing, commercial real estate (non-REITs), and commodities.

The tragedy is that precisely because so many people try to market-time but do so poorly (panic-selling near the bottom) has the average investor massively underperformed the market over the past two decades. In fact, after inflation, the average retail investor has only achieved 0.5% annual returns.

Why is it so hard to time the market? Because it's not just a matter of calling market tops and bottoms.

(Source: Morningstar)

The vast majority of the market's returns over time are a result of just a handful of its best days. For example, in the past 20 years, if you missed out on just 10 of the best single-day gains, your returns would have been cut in half compared to just buy and holding a low-cost S&P 500 index fund. Miss the best 30 days and your returns turn negative. If you missed the market's best 50 days (less than 1% of all trading days), your portfolio would have shrunk by 60% over the past two decades.

Ok, so maybe the market's great historical returns are due to a few outlier mega-winning days. But that doesn't mean market timing is actually impossible, does it? Actually, it effectively means just that.

S&P 500's Biggest Single Point Moves

(Source: Wikipedia)

This is because the market's best days, the ones that drive most of those long-term returns we're trying to capture, all came during the times of peak volatility. For example, the best day in market history was during the Great Depression, when stocks roared higher 16.6% on March 15th, 1933. But that same year also saw 7% and 8.9% daily declines.

In 2008, the S&P 500 saw four of its single worst percentage declines but two of its best days as well. The point is that effective market timing requires you to not just sit out market corrections and crashes. You'd have to literally day-trade your way through periods of gut-wrenching volatility and panic. That's something that not even the most brazen and arrogant hedge fund managers claim to be capable of, so it's best not to try.

3. Have A Watchlist Ready To Take Advantage Of Bargains

The best thing for investors with no investable cash to do when markets slide is nothing. Trust your long-term plan, including risk management that's baked into your asset allocation and portfolio construction. But what if you have dry powder available? Well, then market freakouts aren't times of fear but jubilation. Because when stocks plunge is when even the highest-quality companies go on sale.

Each week, I invest what discretionary cash I have based on the best opportunities I find that meet my personal long-term strategy of:

  • Maximum safe yield (good balance sheets, dividend coverage, recession-resistant cash flow)
  • Good long-term dividend growth prospects (clear and long growth runway)
  • Great valuation (high margin of safety)

Thankfully, something is always on sale, so I'm never at a loss for great things to buy. But that doesn't mean I don't keep several watch lists on hand in case markets tumble and my favorite stocks go on sale. For example, here's my bear market buy list, which I'm adding one stock to per week in my portfolio updates.

Company

Current Yield

Fair Value Yield

Target Yield

Historical Yield Range

Long-Term Expected EPS Growth (Analyst Consensus, Expected Dividend Growth)

Long-Term Valuation Adjusted Annualized Total Return Potential At Target Yield

Texas Instruments (NYSE:TXN)

3.1%

2.5%

2.9%

0.9% to 2.9%

12.6%

17%

Apple (NASDAQ:AAPL)

1.4%

1.8%

2.2%

0.4% to 2.8%

10.8%

15%

LeMaitre Vascular (NASDAQ:LMAT)

1.0%

1.1%

1.5%

0.3% to 2.0%

17.5%

22%

Average

1.7%

1.8%

2.2%

N.A.

13.6%

18%

(Sources: Dividend Yield Theory, Gordon Dividend Growth Model, Simply Safe Dividends, GuruFocus, F.A.S.T. Graphs, Moneychimp)

Now, you can structure a watchlist many different ways. In my portfolio update, I have a detailed explanation for how and why I use the above set-up. But the basic idea is that there are great companies, industry-leading blue chips, that usually trade at too rich a valuation to achieve my target returns (13% CAGR over the long term).

I set up my watchlist so that when the next bear market strikes (the next recession), I'll be able to add great stocks at prices (fair value yield) that make 15+% long-term returns likely over the following decade. Occasionally, a stock on my list will be available to buy before a bear market and even outside a correction. That was the case with TXN, in which I was thrilled to recently open a $5,000 starter position. During the market turmoil, when tech stocks fell especially hard, I was even more excited to add to that position. I was able to lower my cost basis, raise my yield on cost, and lock in even better long-term returns.

Every investor has slightly different goals. You may be focused on growth stocks, not dividend stocks. But a watchlist and bargain hunting are useful, no matter what your investing strategy is. In fact, there are three reasons why I took advantage of last week's tech correction to triple my position in Amazon (NASDAQ:AMZN), which is the only non-dividend stock I plan to own.

Bottom Line: Only Calm And Disciplined Investors Make Money Over The Long Term

It's human nature to get nervous when your portfolio plunges quickly. Loss aversion (it hurts twice as much to lose a dollar as gain a dollar) is hardwired into human psychology. But history has proven there are three things all investors must do in order to use the incredible wealth compounding power of the market to achieve their financial dreams.

The first is not to panic, and remember that corrections are normal, healthy parts of market cycles. They are usually over quickly and don't stop the market from rising in nearly 75% of all years.

By far the most important thing investors can do is stick to a smart, long-term investing strategy that you develop before stocks start dropping. That strategy needs to factor in your risk profile, time horizon, goals, and thus develop an asset allocation that works best for you. It's that asset allocation and portfolio construction, not market timing (which history shows is essentially impossible to do), that will ensure your wealth is protected during corrections and bear markets. So, avoid market timing like the plague, no matter how tempting it may seem or how confident some analyst or economist is in his/her short-term predictions.

Finally, remember that market volatility has a major silver lining. That would be the opportunity to buy great companies at bargain prices. Even deeply undervalued stocks can fall further, which is why I was buying Iron Mountain (NYSE:IRM), Kimco Realty Corp. (NYSE:KIM), Brixmor Property Group (NYSE:BRX), and TXN with both hands last week.

Disclosure: I am/we are long IRM, KIM, BRX, TXN, AMZN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source : https://seekingalpha.com/article/4211542-3-ways-protect-portfolio-next-stock-market-correction

4254