With the recent 5% tumble in one month in both the NYSE and the NASDAQ, I’ve begun thinking about protecting my portfolio from the downside. In an effort to keep you fully invested at all times investment advisors are quick to quote statistics like, “By missing just the best 10 days in the market between 1997 and 2006, an investor’s annualized return would be cut by more than half” but they fail to mention that the NASDAQ peaked in 2000 at around 4700 and is currently at about half of that or 2372. So if you bought near the peak and held the NASDAQ for the last 7 years, it has resulted in a 50% loss.
So I began looking for systems that would profit during both up and down markets and I remembered a system I read about years ago…
Basically, there are three types of markets, up markets (bull markets), down markets (bears), and flat markets. Now of course the market is never perfectly flat, it always goes up and down but if the downs generally equal the ups, in the end you are back where you started (and I would consider that a flat market).
So is there a system that will handle all of these markets and profit no matter which of them we are currently in. The answer is that I think there is. The market trends up about 70% of the time, that is why perpetual bears end up losing in the long run. So we want a system that will profit on the upside. But at least 10% of the time the market is moving down (and often more sharply than it went up) so we want to profit during that time too. And finally it would be nice to be able to profit when the market is just bouncing along going nowhere really.
There is an old quote that says, “a rising tide lifts all boats” in other words in a strongly rising market it doesn’t matter which stock you own because they all go up. But some go up multiples while others barely go up at all. Obviously, you want one that goes up significantly not just barely goes up. One system that has stood the test of time for making money in up markets is the choice of Warren Buffet and is called “value investing”.
Basically, “Value Investing” is looking for bargains, not necessarily low dollar stocks but stocks that are undervalued by the market for some reason or another. These stocks should do well in both flat markets and up markets. Because over time the market will come to recognize the hidden value and the price will increase whether the overall market increases or not. But if the overall market heats up you might get a significant additional boost from that too.
So since the market goes up 70% of the time lets put 70% of our investments in value stocks.
The next phase is to find something that will profit if the market goes down. Obviously, one way is to buy options that profit when the market goes down, unfortunately, most of the time (70%) you would be losing on these investments so that would take a serious chunk out of your profits.
So what if we “shorted stock”? To short a stock is simply to sell it first and then buy it back later. At first it is a bit difficult to understand but basically any transaction has two sides a buy and a sell. Once you have done one of each you are out and done. So does it really matter if you sell first and buy second? Not really. Practically, you can’t sell something you don’t have so you have to borrow it from your broker and then you sell it. And finally you buy it back and return it to your broker. But it is really very simple to do. OK so if we short the high value stocks and they go up, we could lose money so the key is to find stocks that are exactly the opposite of value stocks. You want stocks that are very over priced and getting ready to fall. Preferably so overpriced that they will fall even if the overall market rises.
The tricky part is finding them. There are any number of ways to buy value stocks. There are advisory services that find them for you, and you can even buy mutual funds that buy them for you. But how do you find over priced stocks set to fall? There really aren’t many advisory services specializing in stocks that will go down.
There is a theory called “Dogs of the Dow” that pick stocks that look like dogs but are getting ready to bounce back up. These won’t help us for this strategy. We don’t want Dow stocks they are too likely to bounce back since they are some of the biggest stocks available. As a matter of fact we don’t really want any big well known stocks either.
One measure of how over or under priced a stock is, is called P/E or Price divided by earnings. Typically, a low P/E means the company is earning a lot compared to it’s stock price. These would be good candidates for value stocks (of course you have to look at other factors as well). But if low P/E is good then high P/E should be bad. So stocks with high P/E’s might be a good place to start looking for stocks ready to crash. But occasionally a high P/E could indicate a stock that the market believes is going to be increasing it’s earnings over the next year or two. If earnings double but the stock price stays the same the P/E will halve. So we have to watch for stocks that have rising earnings.
So anyway here is how this system should work. In rising markets 70% of your stocks rise sharply because they are value stocks that you bought at a discount. Some of the 30% of your stocks will rise slightly because the rising tide carries them higher but because they were already overpriced they shouldn’t rise much. Some of the other ones might stay flat and some will fall back to normal P/Es giving you gains on your short positions and covering any losses on your other shorts.
In flat markets, your value stocks should still do OK (rise moderately) because you bought them cheaply. And your “dogs” should fall because they were overpriced to start with.
Finally, in a down market, your value stocks should fall less than the overall market, while most of your shorts should crash and burn losing up to 90% of their value because they were over priced to start with so they have farther to fall. Plus all that falling momentum will usually carry them below their fair value making them bargains. This should make you tremendous profits on the short side. Imagine selling a stock at $100 and being able to buy it back at $10. This is much more likely than being able to buy at $10 and have it go to $100. But the profit is the same. (This happened to many tech stocks in 2000). If 30% of your stocks are shorts and they lose 70 – 90% of their value, they will easily cover any loses you incurred on your long stocks.
The trick to implementing this system is to find really overpriced dogs to short. And I believe I have found a system to do exactly that.
After the recent couple of months of testing I have to admit my preliminary results so far are rather exciting– The system has done quite well for me in both good times and bad. My selections have made money– It has certainly taken a lot of volatility out of my portfolio and protected me in the down periods.
