Five rules for winning in a mature market

 

The expected characteristics of a mature market, and the current market is mature by any definition, differ as dramatically from those of a young bull market as they do from those of a bear market, and possibly even more so. Even so, we are constantly told (mostly by brokerages) to keep investing at the same rate, no matter what the market is doing. To do otherwise, they suggest, is the arrogance of trying to outsmart the market.

That’s wrong. It’s the wisdom of investing based on the expected characteristics of the current market, and nothing else.

And what are current market expectations? Some consider the age of a bull market to be the key metric, while others point instead toward market valuations. Of course, this is longest bull market in history, and the Shiller P/E is as high as it was on the eve of the 1929 stock market crash. So while there is no consensus as to how such expectations should be formed, there is, nonetheless, something approaching a consensus as to what those expectations should be.

And they should be, in a word, poor. Here is a discussion on CNBC in which a number of brokerage houses lay out their forecast annual returns for the market over the coming years. The conclusions range from the low mid-to-single digits, down to a lowly 1% per year. If that’s true, then (horror of horrors), you’d actually do better in bonds!

Avoid Tech

This may be the bitterest medicine of all for some investors, especially since tech seems to rise rapidly during the euphoria that comes at the end of a bull market, but ask yourself why long-term returns are falling. The answer is because the risk/reward ratio in stocks has changed, with the chance of any given stock falling catastrophically much higher than it was five years ago. It is the highest flying stocks — almost always technology and biotechnology — that fall the farthest when the market gets rough.

Some of you may be saying “Even market indices fell by nearly 50% in the last two corrections. Can I really expect worse than that in technology stocks?” What you expect is up to you, but from its high in March, 2000 to its low in September, 2002, the tech-heavy QQQ index fell from 110 to 21, a fall of 82%. They always say not to let fear rule you in the market, but that doesn’t mean you should leave yourself open to total disaster.

Buy steady dividend payers

You will notice that I’m not suggesting you buy stocks with high dividend yields. Such stocks are likely, in fact, to be extremely unsteady in the amount they pay out. Your best bets here are companies that have had long runs without cutting their dividends, or even better, raising their dividends every year.  It is very hard to justify selling a stock beyond a certain level when you know it is very likely that it will be paying higher dividends in the years to come. For that reason, these stocks have limited downsides. Here, in no particular order, are five of the very best:

Coca-Cola (KO)

Johnson & Johnson (JNJ)

Colgate Palmolive (CL)

Dominion Power (D)

Procter & Gamble (PG)


Buy index ETFs

Bearing in mind that in a mature market, the usual risk/reward relationship in the market is skewed in the direction of risk, it makes sense to add an extra level of security, and for preventing calamity, there’s nothing quite like the security of diversification. It is true that you will be giving up, for the time being, the fantasy of beating the market and somehow getting rich while everyone else is getting poor, but there is good reason to do just that. If you can make it through the market’s leanest years getting 1% per year or so on your money, you’ll be in a far better position than most to make money hand over fist once times become good again.

Your best bet here may be the Vanguard S&P 500 ETF (VOO), which will follow the performance of the S&P 500, while charging a lower expense ratio than the more well known SPDR S&P 500 ETF (SPY). Or, for even broader diversification, you could buy the iShares Russell 2000 ETF (IWM). A basket of 2000 stocks, it is about as diverse as it gets, and while its performance has been lower than the S&P 500 ETFs in recent years, there is really no way of knowing which of the two will do better in the future.

Buy companies in defensive industries

The market is full of defensive industries, which is to say, industries in which companies do well even when times are bad. By owning stocks in such industries, you defend yourself not specifically against market correction, but against recession. There is good reason to do so, however, as corrections and economic crises tend to happen together. Consider the 2008 financial crisis. Before the crisis, the market and the economy were moving forward, though at a somewhat lackluster pace, when the a sudden debt crisis threatened the economy. Before anyone quite knew what was going on, let alone how to fix it, the stock market had taken a catastrophic dive. As a result of that dive, corporations, private citizens, and even the government, found themselves without free cash to fix what had gone wrong, and everyone settled in to a protracted period of climbing out from under debt.

The point is that a stock market correction can be preceded by, yet still contribute to, an economic crisis, and the last thing you want is a bunch of tech stocks or even cyclical stocks when this happens. As a sort of super-defensive stock, I favor Johnson & Johnson, which is part consumer staples giant and part pharmaceutical giant. Each of those industries is defensive, though in slightly different ways. If you want to go further, you might want a counter-cyclical. Some say there is really no such thing, but traditionally, the industry closest to being truly counter-cyclical is alcohol. In this industry, I favor Brown-Forman (BF-B), the makers of Jack Daniels Tennessee Whiskey. 

Hedge!

There are two main ways to hedge using options, and to keep from losing a great deal of money to trading fees, it is wisest to use these methods when you have put the bulk of your portfolio into a small number of issues, preferably index ETFs. The first method is to sell calls on your issues. When you sell calls, it is best to sell them with strike prices a bit out of the money — say, five to ten percent — and to sell them with expiration dates four to six months out. When you sell calls, you’ll receive money up-front, and as long as your issues don’t rise beyond your strike prices, there is no other effect. If your issues should rise higher than your strike prices, you’ll still get the up-front money and the profit of five to ten percent, you just won’t get to keep anything beyond that.

If that seems a bit complex, the second way, buying puts, is even simpler. Simply decide how much downside you are willing to accept in the issue — this should be in the 5% to 15% range — then buy puts with a strike price at that level. You’ll pay money for this, but it will limit your downside to the specific level you choose, even if the market falls much, much further.

And, of course, these two methods work splendidly together, forming what is called a “collar,” so called because there is a limit to both your potential upside and your potential downside. If you consider that in a mature market, downside is greater and upside smaller than at other times, you can see that the collar becomes a more and more sensible plan as the market grows more and more mature.

Symbols: CL D JNJ KO PG
Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

You May Also Like