Blog 13 - Prepping for Corrections

"You get recessions, and you have stock market declines. If you don't understand that's going to happen, then you're not ready. You won't do well in the markets."— Peter Lynch, Former Manager, Fidelity Magellan Fund

As much as market corrections are dreaded, they are an essential part of the free market. Healthy ecosystems need to periodically purge the weak. The stock market is no different. Unhealthy markets and business practices can be sustained well after their "expiration dates." Then, in the blink of an eye, the markets convulse.

Despite our preference for market stability, volatility is the norm. Those who are better prepared will reap the benefits. And it's never long to wait between events. While the definition of a market is "uncontrollable", an investor can learn to transform defensive fear into becoming an opportunist through:

i. By Portfolio Design:

• Sticking with quality mid-to-mega cap stocks

• Choosing globally diverse businesses based in North America

• Deploying 3 degrees of diversification

ii. By Portfolio Management Techniques:

• Contrarian buy-in practices

• Contrarian rebalancing

• Contrarian Covered Calls

• Contrarian cash-secured Put contracts

• Contrarian cash and debt management

• Portfolio insurance

iii. By Improved Capital Markets Behaviors:

• Following an investment plan reinforces confidence in the long-term mission.

• Triangulation of research leads to stronger stock convictions.

• Setting proactive trades allows the investor to set terms, minimizes trading costs, and reduces reactive mistakes.

Since market uncertainty clashes with the human preference for certainty, let's explore how to cope through the chaos. It starts by building perspective.

Risk Framing

The #1 challenge to becoming a contrarian opportunist is "FOMO". No-one wants to miss out on a rising market. With markets trending upwards 64% of the time annually and 100% of the time over all rolling periods of 10+ years, being 'contra' the markets is a difficult perspective to take. Yet, most of us live in a constant state of fear about that next pull-back.

This blog is written to encourage that being invested for the long-term and being prepared for a significant pull-back do not have to be mutually exclusive. In other words, just being better prepared through adjustments to your portfolio design, awareness of contrarian tactics and re-framing that market corrections are an opportunity as powerful as investing early into a next generation stock.

Unfortunately, when market chaos strikes, instead of perking up to embrace the opportunity, most investors prefer to retreat. What may have been a correction on fundamentals can then become a behavioral stampede.

Yet market corrections are the greatest opportunity to make wealth gains relative to our investing peers. Attempting to time out of the market by selling into falling prices is most often a failing tactic and, more often, results in falling further behind. Those who stay the course will do just fine. And those who are better prepared to seize the moment to average down are true contrarians. Therefore, it's a matter of perspective how we handle the 'moment'.

Attempting to buy devalued stocks during a market correction is similar to buying distressed real estate. Most of us fantasize about the opportunity to buy quality properties at discounts, but when all properties are under duress and you have no cash, the situation is irrelevant. Wishful thinking but bad planning. Illiquidity prevents us from extricating capital to make a bid.

Stock Market's Three Under-Appreciated Traits:

1. In the short-term, the market is highly volatile.

2. In the long-term, the market is highly predictable.

3. At all times, the market adjusts as required to create liquidity.

Being a provider of liquidity is a strategic advantage. Here's how to gain the upper hand.

Mental Preparation

With the stock market going into distress (on average) every 2.5 years over the course of the last 75 years (Figure 1), an investor can plan around this cyclicality more easily than for real estate markets whose cycle can last up to 20 years.

Figure 1 Source: American Century Investments

Those who can look through the panic to see the opportunity likely share the following traits:

1. Trust the resiliency of the markets

2. Hold conviction in quality investments

3. Have confidence in their risk management plan

4. Have already prepped their portfolio

Portfolio Staging

A portfolio plum with quality stocks is a good beginning. Yet being proactive could diminish a lot of unnecessary trauma. Here are seven measures to consider before the next upheaval:

i. Lowering the Portfolio's Volatility Exposure

A portfolio with a Beta greater than 1.0 will react stronger than the general market during volatility.

• Trim exposure to high-performance stocks – They may be amongst your favorites but are equally likely to be leaders to the downside.

• Reduce exposure to higher Beta sector stocks (Technology, Commodities, Consumer Discretionary, Industrials, Financials) into more defensive sectors (Telecom, Healthcare, Utilities, Pipelines, Real Estate, Consumer Staples).

• Close out ITM Put contracts – Selling Put contracts is leverage. Close out positions with high 'gamma' (in-the-money positions). These securities react more intensely to each $1 change in the underlying share price. The best time to redeploy leverage (i.e., selling in-the-money Put contracts) is during market selloffs.

• Reduce or eliminate non-core assets (e.g., small caps, foreign stocks, IPOs, leveraged ETFs, illiquid alternative assets, etc.)

Note: Beta figures for individual stocks and the weighted average for the portfolio are available on your trading platform.

ii. Confirm 3 Degrees of Diversification

• Rebalance economic sectors in proportion to the MSCI Global Index¹

• Ensure non-duplication of the 69 industries.

• Verify that stock correlations are reasonable (<+.06) – use the Auto-Correlation Platform to identify, then reduce/remove any highly correlated pairings.

  
  

iii. Deploy Covered Calls for More Cash

Sell extended OTM Covered Call contracts to generate income for the portfolio and dampen volatility. Ordinarily, the target is to sell Deltas of 0.20 or less. In anticipation of a market correction, consider selling lower Strike Prices with a higher Delta (0.35+).

Non-Critical Risk: If the underlying stock prices were to continue to rise, CC contracts with higher Deltas (lower Strike Prices) could now be vulnerable to being exercised out of your portfolio. However, this is essentially non-critical risk. Once the underlying share valuation equals the Strike Price, all gains above the Strike Price will be neutralized by a deterioration in the value of the CC on those same shares. At maturity, when the position is assigned away, new positions can be discretionarily reintroduced by lump-sum, DCA, or by selling ATM/ITM Put contracts. But having a higher cash position may also provide greater peace of mind if the market remains at elevated P/E multiples.

iv. Raise Cash and Margin/Debt Reserves

Cash and debt reserves are powerful strategic advantages to hold during market pullbacks. As the market hits new 52-week highs, continue with disciplined trimming of stocks and continue to raise new cash in the numerous ways outlined in Blog #9.

v. Pre-Set Trading Orders to Preserve Gains

To lock in some of your capital gains, set a series of Trailing Stop-Loss (TSL) orders at intervals totaling up to 25% of a stock's value. Each TSL order will trail behind an advancing stock until triggered by a market pullback. If untriggered, when a stock's price rises further, so will the TSL order continue to advance, and so will your eventual gain.

SL & TSL Guidelines:

• Upon opening a position, initially set a Stop Loss order (SL). This would set a floor under a position such that if a stock's share price were to deteriorate more than 5% (as an example), it would be triggered and remove the security from the portfolio. Typically Stop Loss orders are set at about 1-3% below the current FMV. Tighter at 52-week highs, and less stringent at 52-week lows.

• However, as a stock's share price rises, set a Trailing Stop Loss order (TSL) to secure that the position should only be removed at profit.

• Set a large enough gap between the "Stop" and "Limit" prices to improve the chance of triggering a trade particularly if the market plummets.

Potent Combo: Stop Loss (SL) and Trailing Stop Loss (TSL) trade orders are potent backstops to protect some of the portfolio's gains and core capital. By proactively setting SL and TSL trade orders, a sudden correction should not require spontaneous trade decisions, and a significant proportion of the core portfolio should be triggered into cash, which should reduce the need for portfolio insurance.

vii. Consider Setting Partial Insurance Coverage

If the above six risk management measures have been deployed, buying insurance coverage becomes discretionary. (Chapter 25 of The Investing Oasis)

The Opportunity Mindset

By deploying any or all the above-noted risk preparation measures, an investor might begin to view a market correction more opportunistically. Instead of relying upon gut instinct and market timing, being proactive will also reinforce confidence and provide some peace of mind. By deploying tactics contrarian to the masses, an investor could lessen the overall impact, while also being in a favorable position to accelerate their wealth recovery more substantively.

Notably, the greatest gains are often within days of the worst drawdowns.

Summary

Like earthquakes, it is entirely luck that anyone correctly guesses the arrival date of a market meltdown. The best practice is to be better prepared than your neighbor. The next best practice is to be well prepared compared to what you were before reviewing your risk management plan.

Managing through a market correction is not much fun and is like trying to rally your camels during a desert storm. It ain't gonna happen. So, if you respect that the markets periodically purge the weak and don't want to be one of them, stick with quality assets, be proactive with your portfolio preparations, and take confidence that this plan will provide you with a strategic advantage when the next downturn arrives.

It won't be long.

"The pessimist complains. An optimist expects things to change. A leader makes the adjustments."— John Maxwell, Author, "21 Irrefutable Laws of Leadership"

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Resources:

• The Investing Oasis - Chapter 25: "Protection & Hedging Techniques"

Footnotes:

1. MSCI Global Index provides sector weightings for global equity markets ↩

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

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The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.