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The Sell Decision: What to Do After a Severe Market Meltdown

by Donald Cassidy

As usual, no one “rang the bell” when the 2002–2007 bull market topped out in October/November a year back. Thus, from where we stand now, it would seem somewhat lame to say ‘these are the reasons you should have lightened up long before the recent meltdown.’

This article, instead, will focus on what to do in and after a severe bear market if you are investing your own portfolio of individual stocks.

When to Sell: Normal Times

First and foremost, you should keep in mind a few selling guidelines that should be used in normal times, which surely we will again enjoy.

Three major groups of reasons exist for selling stocks in normal times—well before a climax marks a bear market’s final end.

Listed below are two major clusters of reasons for selling in normal markets [for a longer discussion of when to sell, see “How to Nail Down Your Profits: 20 Questions for a Disciplined Approach,” in the August 2008 issue of the AAII Journal; available at AAII.com].

Company-related reasons for selling:

  • Sell if you would not buy the stock again now at today’s quoted price.
  • Sell if your original assumptions concerning the company (your rationale for buying the stock) did not prove accurate.
  • Sell if company fundamentals are starting to turn bad.
  • Sell on the rebound in the aftermath of material, unexpected bad news.

Price-specific conditions for selling:

  • Sell when a stock reaches your original price target.
  • Sell if the stock price is not moving and is likely to stay that way (assuming the price inertia cannot be blamed on the overall market).
  • Sell if there are significantly better opportunities for purchases.

If you have built your individual stock portfolio in a disciplined manner, and you have made sales in a disciplined manner, you should have a relatively solid core portfolio of high-quality issues that have continued to perform fundamentally and have not run up to unreasonable price levels. They are stocks that have given consistent indications that they can be held through good and bad in the market. All other stocks will have become sales well before you face a market-wide bear market bottom because:

  • They worked as planned, achieving your price targets;
  • They became unreasonably priced;
  • They were wasting your capital’s time value by going nowhere; or
  • They developed significant fundamental problems.

Bear Market Basics

Markets are moved by two overriding types of forces: fundamentals, which control the long term, and psychology, which rules the short term dramatically and the medium term more quietly. Psychological effects on the downside are strong: Fear is a powerful driver. On the way down, each subsequent bottom in a bear trend is typically characterized by increases in fear and therefore in trading volume, and maybe a hint of panicky dumping.

The final downside is most violent, and usually sees the greatest trading volume. Selling pressure becomes exhausted as large numbers of the previously brave finally capitulate and sell even at obvious bargain levels. As a large crowd jumps overboard simultaneously, the moment they are finished is why and when prices hit a bottom.

Weathering a Severe Market

When you are caught in a severe market downturn, the bottom-line question is: Will capitalism continue to function after the panic ends?

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If the answer is “yes”—and there really is no reason today to think that it won’t—then there is no reason to sell at foolish levels.

Buying will understandably be emotionally difficult in a severe drop. Those who can do it are demonstrably rational and therefore also calm enough to have sold with discipline as the prior highs approached or soon after they passed.

One important factor for ongoing success is what and whether to hold or sell after a major drop has occurred.

Once the selling climax passes, there is a lift in the market. But its effect is significantly different across various kinds of stocks. For some issues, there is a sharp snap-back rally; for others, very little improvement.

Just as it is not advisable to sell directly into a big drop, it is prudent to reassess positions after the selling frenzy has subsided and an initial bounce in prices has begun. The object, as always, is to decide in real time what to sell and what to hold.

Selling should not be urgent because pre-bear-phase tactics will assure you have enough cash to survive. Most importantly, your asset allocation strategy should include the basic principle that your stock investments are long-term holdings, and any money needs within the next five years should be held in money market funds or similar short-term investments.

In reassessing your holdings, you must look forward to future prospects, rather than backward at now-irrelevant old (higher) prices. Although specific micro conditions will differ in each market bottom’s aftermath, here’s a generalized list of which stocks have in the past tended to fare poorly and which stocks have tended to fair better after a market panic.

Stocks That Don’t Fare Well

Stocks prone to sub-par performance in a post-bear market environment are the following:

  • Thinly traded stocks, and those covered by few or no analysts;
  • Competitive laggards in their industries (examples: Sears, Ford, Vonage);
  • Stocks in recession-sensitive industries (for example, consumer durables, travel, semiconductors);
  • Brokerage firms’ own stocks (the public will be slow to return to active investing); and
  • Discredited and panic-trigger related industry groups.

What are discredited and panic-trigger-related industry groups?

These groups differ from one market cycle to another, and will depend on the headlines of recent months. For example, brokerage stocks would have been poor choices to hold after the 1987 crash because of all the controversy surrounding program trading. Large international banks were laggards in the fallout after the LTCM hedge-fund debacle in 1998 because of their lending exposure. Anything with a Latin American tinge became taboo for a while after the Mexican peso devaluation in late 1994. Technology remained in the doghouse for seemingly a dog’s age after the 2000 bubble burst. The common thread is that, although certain stock groups may indeed be cheap, they will not yet be ready to rebound soon after a related crisis.

Make sure that your expectations are not in direct conflict with prevailing consensus and not based alone on your personal judgment of what may or should happen. You may turn out to be correct, but the market is bigger than any individual.

Bear-Resilient Stocks

By contrast, some groups tend to act well in a post-bear market environment, especially if the market drop itself drives prices to incredible levels. Of course, the more unusual the values created, the briefer the opportunity window and the sharper the initial snap-back rally will be.

Groups that are recession resistant or perceived as most likely to survive hard times are as follows:

  • Recession-resistant industries (foods, grocers, drugs, utilities);
  • Big names with corporate staying power (e.g., IBM, ExxonMobil, General Electric, P&G, McDonald’s);
  • Trade-down concepts, such as low-cost restaurants and discount retailers (recession “beneficiaries”);
  • Companies in very basic businesses, providing good yields from well-covered dividends;
  • Companies with low price-earnings ratios or low price-to-cash-flow ratios not already otherwise in the above list;
  • Companies at or below book value and with positive earnings per share trend estimates;
  • Companies with low debt-to-equity ratios (perceived as low in risk), or high cash per share;
  • Unleveraged closed-end non-junk-bond funds.

Assessing the Bear

Stock markets tend to exhibit two types of major downturns. An astute investor must in both cases try to assess calmly whether the market (wealth) damage itself and/or the underlying economic causes (if any) will likely lead to a recession, or to general expectations of one.

Subsequent market action, especially regarding which stock groups will lead or lag, is likely to be different according to the expected economic fallout of the market damage.

The first type of cataclysmic market action is not apparently caused by some specific bad news. The market is basically reacting to itself, or more accurately people react to the market’s recent negative price action by giving up hope and selling out mainly to relieve their stress. (In some cases liquidating sales may be triggered by margin calls, so all selling may not be entirely voluntary.) Two examples of such untriggered drops were the sell-offs of October 1987 and July 2002. Both culminated in declines, albeit of differing durations and depths.

The second type of meltdown is one directly and immediately caused by extremely bad news events. These may have been unforeseeable (the JFK assassination in November 1963 and the attacks of September 2001) or may have been part of a developing cluster or atmosphere of problems (our current financial market crisis). But clearly investors are responding in such cases to events rather than merely to the earlier price decline per se.

Market drops caused by bad news have a greater potential to lead to economic weakness or significant sector damage.

It is important to step back and coolly consider whether the news carries likely broad economic effects. One of the important considerations here is the degree of government response and its likely effectiveness. Within the list of news-driven market drops are some which, while shocking on their face and damaging to people directly involved, do not have wide economic fallout. Examples are major surprise bankruptcies such as Enron and Worldcom.

Not all negative events that can drive market drops are within the power of Washington to contain, however. For example, in 1973 OPEC quadrupled oil prices overnight, from $3 to $12 per barrel. Complain as it might, our government was powerless to reverse the action or to contain the inflationary and dampening effect on retail sales that followed. A recession ensued.

The open question at this writing is whether the public’s confidence will be shaken badly enough by the financial industry events of recent months so as to cause a recession. Two serious negatives are the wealth effect on consumers already battered by gasoline and food inflation, and the inability to continue using home equity as a cushion for consumption. If broad consensus develops that a recession is inevitable, such thinking will be somewhat self-fulfilling. Investors will need to adjust their hold/sell/avoid (and bargain-buying) lists accordingly. In the past, it was common that industry groups associated with causing the economic or stock-market malaise would clearly be out of bounds as early leaders in the market recovery once the dust had cleared.

Ironically, in the case of 2008, it is possible that if the banking bailout is effective (because it “must be” to preserve the economy’s infrastructure), then middling to strong large-bank stocks might contradict old norms and become buys rather than sells since they are effectively assured against failure.

In the present circumstances, investors would do well to create two separate lists of sell-vs.-hold decisions by industry and individual stock names, depending on how the economic scene plays out.

One final aspect that should enter into an investor’s sell/avoid/hold calculus in the final weeks of 2008: Tax-selling season is here. It could be heavy this year, given the stunning losses from market highs in late 2007.

Donald Cassidy was senior research analyst for Lipper Inc., a Reuters Co., from 1990 to 2006. He recently founded the Retirement Investing Institute, a nonprofit educational foundation, and is the author of five books on personal investing, including “It’s When You Sell That Counts” (now in its third edition). Contact the author at don@R-I-I.org.


Discussion

Donald Smith from CA posted over 2 years ago:

A very good article.It had the effect of stiffening my resolve to do what must be done in these advverse conditions..Thank you
Donald Smith


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