[Ed. note: Today we have another article from Jim Skelton, the Blind Squirrel, who writes to share what he learned about investing in his many years in the trenches as a financial advisor. He has agreed to our trading restrictions, the opinions he expresses are his own, and we haven’t reviewed, approved or screened his ideas. His previous articles can be seen here.] 

Greetings once again to all the Gumshoe Nation! Your resident Blind Squirrel here once again to share some thoughts and musing I hope you may find helpful in the quest for investment excellence. By choosing to devote time to reading the posts here by Travis, our intrepid leader, Doc Gumshoe, Myron Martin, and the newest (and most welcome!) addition to the lineup, Dr. KSS, you’ve already demonstrated the desire to become better and more well informed investors. Especially those of you that have chosen to step up to the esteemed level of an ”Irregular” member and get all the news and comments in expedited and consolidated manner. Not to mention the material that is simply unavailable to non-Irregular readers. If you’re not Irregular, well then, you’re simply Regular. Who wants to be thought of as ”Regular?” Sign on today! Best $49 bucks you’re likely to spend all year. BTW, Travis doesn’t pay or even encourage me to say things like that. It’s just how I feel.

Let’s get on with it now.

Before I start to discuss this months topic – ”Market Acrophobia – The Fear of Falling” – I want to revisit last months column for a moment and recognize a few of our members for some unselfish and helpful commentary they made about my topic at that time. Record keeping, if you recall.

One of the truly outstanding things about this site is the ability for all readers to participate in the discussions. On most sites it’s a one way street: the writers give their views and opinions and you can’t respond in any public manner with comments of your own. Not so here. This is a most democratic (sorry, Republicans) site that not only allows for discussion by means of direct reply to writers and/or opening a totally new mini-blog discussion on any and all germane subjects, but encourages this interaction. And it’s that interaction that can provide the energy, the new ideas, the concepts that can boost each individuals level of knowledge and competence. That, my friend, is a beautiful thing!

In response to my comments on effective record keeping and the importance thereof last month, I got the following comments from Gumshoers about ways they went about this process and the sites they use to do so. The following is a short list of a few I found helpful after I took a look at them. I may even use a couple in the future for myself. I urge you to go to the sites referenced and at least look at how they might give you an edge in keeping up with your holdings and performance. Some charge a small fee, some don’t. One requires you to have an account at the firm mentioned. So use what you can, if you can.

(1) From Carl Brady: Carl suggested you consider using an investment strategy called ”The Trending Value Portfolio.” This is not web based, but rather comes from a book entitled What Works on Wall Street by James O’Shaughnessy, 4th edition, p. 583. Carl said the strategy uses 6 value factors in screening for a portfolio – P/E, P/B, EV/EBIDTA, Yield, Price/Cash flow, and Price/Sales. From that screened universe of stocks (not sure how big the universe is at outset – the S&P 500 maybe?), you take the top 10% of those. Then pick from 25 to 50 of these issues to own. The criteria for making that choice can be highest price momentum, or perhaps another metric you prefer.

Carl posted that he has a web page of his own (I have yet to visit it, so can’t comment) that can be found at http://www.invessense.net .This shows his current top 50 picks using this strategy. Be advised, I am not endorsing the site or the strategy in any way, just pointing it out to you for investigation if desired.

(2) From Walter Schwager. Walter likes to use http://www.globeinvestor.com to create watch lists. He also recommended http://www.globeinvestorgold.com for those of you interested in Canadian issues. Both sites are Canadian based.

(3) From Carol Clemens. Carol suggests using a program from Quant IX called ”Investment Account Manager.” This is probably fee based. Carol has used it for some 14 years now and couldn’t imagine getting along without it.

(4) From Paul Merk. Paul, a ”Senior” investor who says he simply has too many miles on the odometer to care a lot anymore, and a substantial array of individual investments in his portfolio that defy his interest in keeping up with each and every one, has found using a program from Qmatix called ”XLQ” to be very helpful for him in his situation. It has a small subscription fee attached. I’m thinking Paul has reached that investment Nirvana we all aspire to; accumulating too much money and having too little time to devote to the continued pursuit of more. Congrats, Paul. I hope someday to be facing this very ”problem” myself!

(5) And last, yet most certainly not least, a suggestion from our very own Myron Martin, the Guru of Gold and the Maven of Miners. Myron suggests using a program from CIBC (a Canadian investment bank/brokerage) called ”Investors Edge” to get daily updates in three categories he deems essential: highest volume increase stocks, highest percentage increase stocks, and breakout stocks. With that data in hand, Myron transfers it to a format he created to track market sentiment and establish what he thinks will be good entry points. He currently has 15 watch portfolios with 6 stocks in each under his careful and experienced eye. While we can’t replicate the results he gets by following some hard and fast rules, we can see what he is following and tends to favor at any point in time by reading his posts here on-site. But at least now we know how Myron spends his free time!

My thanks to those mentioned above and the others who commented last month. Keep ’em coming, I’m learning a lot about all of you as a group and your various levels of involvement and experience. At this point all I can say is WOW, this is one large and very diverse group. There are some truly well-informed and educated members. And there are many, many more who are rather new to this investment process and appreciate advice and guidance. In all probability I’ll be directing my topics more to that latter group than the former. But who knows; we ALL have the need to keep reading and learning because one never knows when something will appear that they hadn’t been exposed to yet or gotten a firm understanding of. I’m feeling my way forward and finding my place in this universe. I will use that to direct my future postings and subjects accordingly. Since I am what I suppose you could call a ”Market Generalist”, as opposed to being a specialist in one field or another as our other regular columnists are, I can range far and wide in my writings. But I need to find the sweet spot that fits my abilities and your desires. So feel free to let me know what you think, good, bad, and ugly. What doesn’t kill me will only serve to make me better!

Let’s turn our attention now to this months subject du jour: facing the fear of a possible general market correction/decline.  Acromarkephobia, to coin a word.

Having lived down here on the East coast of Southern Florida, the area they call the Palm Beaches, for the past 42 years, I’ve learned a thing or two about hurricanes. I’ve learned that they will and do come to wreak havoc on our real estate and lives from time to time. I’ve learned that the forecasters, the National Hurricane Center and all associated news organizations do the best they can to give us fair warnings of the arrivals of these beasts. I’ve learned that those forecasts, no matter how well intentioned and reasoned, seldom are right. I’ve learned that when they are right, and one actually hits the area, no one is exempt from the fury and carnage they leave in their wake. And I’ve learned that there is little one can do when you find yourself in the line of fire to protect from all damage. The best you can do is be aware and then be prepared – long in advance of the need being right on top of you.

It occurs to me that there is a great similarity between the forecasting and preparedness for hurricanes and that for market declines. Both are known to exist and you can be assured that, sooner or later, you will find yourself smack dab in the eye of the storm. Both will take no prisoners when it comes to the damage they will do to property and lives. Both have legions of professionals watching for them and giving advice as to where they will strike hardest, when they will arrive, and what to do to try and minimize the damage. And, perhaps most importantly, both are mostly unknowable as to size, duration, and exact timing of arrival. Scary stuff indeed.

In the case of hurricanes, anyone who chooses to live in this part of the country has to accept these facts in order to enjoy the overall great weather and environment that South Florida offers. Likewise, with market declines, anyone who wants to invest his or her money and enjoy the benefits of rising values and wealth must accept the risk of market declines and losses. You can’t get the benefits without the risks.

There will be times when it seems the risks have just gone away, and it’s all milk and honey throughout the land. So we grow complacent, content, inattentive. Then, with little warning, the winds of change blow in like a lion springing from cover onto the gazelle. When that happens, we learn yet again that history does repeat itself, and prices must be paid. So how does this analogy relate to us investors and advisers today? Lets have a look at some data and find out.

Since mid-2009 the general market has been on a upward run of significant proportion. A true ”Bull Market” as those are generally defined. And a few sectors within the overall market have done better – some much better – than the overall market. We’re now some five years into this Bull with only a couple minor setbacks along the way. Investors who have chosen wisely have prospered greatly. And the kind of outsized returns we’ve been getting have slowly come to be thought of as the normal state of affairs. The very idea of a 10% – 12% average annual rate of return is scoffed at by most everyone. Even gains of 20% are nothing to be proud of. We seek and expect minimums of 25%+ on a year over year basis. Good advisers are fired for getting returns of less than that, and everyone is now an expert – in their own eyes, at least. The markets have made investment gurus of us all and this party is going to go on forever. Right? Am I right?

All of which is well and good except for a couple little things. First, it won’t continue forever. An annual return of 20% or more isn’t anywhere the long-term historical norm, nor ought it be expected. A return to the mean of that 10% – 12% per year average will happen in due course. And if you believe that that the returns of recent years cannot and will not be sustainable forever, what if anything can you, should you, be doing to prepare for the storm?

Before I try to give you some ideas to consider, I’m going to post up a few comments below. Read each one carefully and, as you do, ask yourself if you think the statement is accurate or not? Is it good advice, or just hokum? Am I making it up just to trick you into an answer or could I be serious? Read and decide on each point.

(1) ”Most stocks fluctuate ~50% from top to bottom each year.”

(2) “If the DJIA rises another 20% from here in short order, the chances of another big decline increase considerably.”

(3) “Assuming you agree with that forecast, how can you prepare? Best advice: mostly by doing nothing.”

(4) “The first mistake people make is hedging a portfolio, anticipating a drop in the market. Hedging is a tricky business even the professionals haven’t mastered.”

(5) “The second and more prevalent mistake is the ritual known as lightening up. ‘Better safe than sorry,’ they tell themselves. ‘I’ll wait for the day of reckoning and I’ll snap up bargains left and right.’  Then when a correction eventually hits, and prices drop like stones from a bell tower, they don’t buy out of fear of being too early, and that the decline has further to go. Then when prices stabilize they tell themselves they will buy when the price goes back down to the lows it set at the bottom of the correction. The bottom line for them is that they wind up on the sidelines with cash doing nothing and the opportunity lost.”

(6) “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”

Now that you’ve read these statements, where do you stand? Agree? Disagree?

Time now for a little disclosure.

These statements are from an article in the September 1995 issue of Worth magazine. Almost 20 years ago. The only quote I had to take a tiny bit of literary license with is #2 where I use a rise of 20% in the DJIA as the benchmark. The actual statement said “if we tack on another 1000 points from here and the Dow rises to 5700 …” Using the number of points would have dated the story and ruined the surprise. But that isn’t what is important. The important part of that little exercise is who wrote the story. And whether or not you think he is someone whose knowledge of markets and investor behaviour is worthy of respect.

The author is Peter Lynch, he of Fidelity Magellan Fund fame whose ability to call markets and pick stocks is legendary. A man who, in my opinion, sits atop the mountain of investment advisers and stock pickers alongside Sir John Templeton and Warren Buffett. If you agree with that, it’s hard to refute the wisdom of those nuggets of advice.

The article, entitled “Fear of Crashing”, was written at a moment in time when a lot of the pundits had begun to call for a market correction at the least, perhaps an end to the long running Bull Market that had been in place since 1982 when the Dow began the rise from 777 on August 12, 1982, and gained just over 1500% to close at 11,722 on January 14, 2000, the date that market watchers have assigned as the official end of that very extended Bull Run. Yes, there was one major reversal during that time frame – the so-called “Crash of 1987” – when the DJIA experienced it’s largest daily percentage loss in Dow history. But as horrific as that crash was, it was just that – a crash – fast, severe, and not of much lasting duration. Not the end of the overall trend to the upside, which is why the ”Bull Market” label remained intact.

Lynch made no predictions as to the likelihood of an imminent correction or crash of any sort in the article. He was/is smarter than that, not allowing himself the ego trip of making a call on such an unknowable thing. Instead, he offered his thoughts on what to do in order to prepare yourself when that event appeared. And that advice was quite simple: Do nothing much at all. He took a much broader view of markets than what we see today on the broadcasts from the pundits who will pretend to “know” what is coming, and when, and why. He understood that by doing little when the storm was upon us, by riding it out, and assuming you had a portfolio that consisted of quality dividend paying equities, time was the only reliable way to restore the value of a portfolio. History proved the wisdom of this approach then. I believe it will do so again when the storm clouds once again gather and the winds blow.

But I also recognize that times have changed. Information is much more readily available, intricate software programs have been developed that, with computers and the capability to crunch so many numbers now available to us at a moment’s notice, investors today are not often satisfied with such a simple solution. We all want to believe that we can get in front of these situations and do things to help us better survive the events, be they a Flash Crash, a Crash, a Correction, or a bona fide Bear Market. Each of those terms have different meaning, usually defined by two parameters: duration, and percentage drop. Investors need to understand the difference in each and use the right terminology when discussing them.

Generally speaking, a Bear Market is an overall market decline that will last for at least six months or maybe extend for many years. The longest Bear market I can recall was from 1966 through 1982. The economy was stagnant and we were in an inflationary monetary environment. Those of you who, like me, are of a certain age will remember the days of 16% money market fund rates and getting AAA Munis at 12% during that stretch of time. Sounds good until you recall that at the same time inflation was running just north of 21% per annum, so you were losing about 6% – 8% per year in purchasing power.

The Dow crossed 1000 for the first time ever in November 1972, then almost immediately began to fall – very slowly, yet fall it did, not to see 1000 again until 1982. It fell some 45% during that period to a 20-year low. Now THAT’S a Bear market! Investors stopped calling their brokers to ask how the market was doing. They just came to be conditioned to know it was sinking – the question wasn’t one of direction but rather of degree. The last official Bear Market occurred from 2007 through 2009. It was marked by setting multiple volatility records during the Fall of 2008 while declining severely, then entered another big decline in early 2009. Top to bottom, the DJIA went from a then-record level of 14,164 down to a reading of 6,547, a decline of 54% in 17 months.

A market ”Correction,” on the other hand, is usually of much shorter duration, lasting for a few days to maybe a few weeks, and has a decline of about 5% – 20%, top to bottom. Historically speaking, we get a correction of this sort about once every two years. Sometimes even more frequent than that if we’re in the midst of a fast Bull Market and valuations are skyrocketing. Since 1900 we’ve had at least 60 “Corrections,” some of which came and went so fast people hardly noticed. Others, such as what we just got through in January of this year (2014) were of a size significant enough to get everyone’s attention but didn’t last long. The market took off to the upside on February 2nd or so and has recovered most if not all of those January losses.

And then we have “Crashes” or “Flash Crashes.”

It’s easy to recognize a real Crash when you see it. It happens in a very compressed time frame, usually from one to maybe three days. It has a huge effect on the indexes with declines of 20% – 50% or so the norm. Crashes can be triggered by any number of events or circumstances, but overall market valuations usually play a large role in setting the scene for this event to occur. Blood runs in the (Wall) Street and sometimes on Main Street as well – literally and figuratively speaking. But the silver lining to a Crash is that they usually began a recovery fairly quickly and actually can create some of the best buying opportunities for investors who have cash on hand and the faith that a recovery will follow in due time. Cash we can sometimes find… but that Faith Factor, well, that’s another story altogether and much harder to come by.

And finally we have this relatively new form of a Crash called the “Flash Crash.” This is defined by a huge drop in the indexes occurring in just a few hours if not indeed a few minutes. The last one of these happened on May 6, 2010. At that time the world was deeply troubled about the banking and economic situations in those Nations that had come to be called ”PIGS”. That acronym stood for Portugal, Ireland, Greece, and Spain. On that morning of May 6, the Greek government essentially collapsed and declared total economic insolvency. People lost everything they had in banks and financial institutions in the country. There was real blood in the streets of Athens as citizens rallied and fought with the police and army – it was brother against brother, the ugliest kind of conflict. and throughout the country riots developed and spread. The international monetary cabals had yet to come up with a plan to save the economies as best they could, so sheer panic ruled.

In the US markets, bedlam reigned supreme. In a YouTube video of a 10 minute segment of a financial program on CNBC, you can watch and hear the thing unfold.

It is fascinating, mesmerizing, and frightening. I’d bet good money that if you watch it once you’ll go back and watch it again. It’s really hard to believe what you are seeing actually happened. Our market had gotten off to a bad enough start with those satellite feeds from Greece showing the carnage and the reporters telling the tale of economic disaster. When we were down some 250 points or so, the powers that be at CNBC called in Jim Cramer to comment and give his take on events as they happened. In the few minutes it took for him to get mic’d up and seated the Dow was down about 450 points. As he and the show’s normal host began to try and talk about what was happening, the market went into free fall. They couldn’t talk fast enough to keep up with the declines. During that little 10 minutes the Dow went from being down 492 points to 10,375 to being down 991 points to 9,886! All in 10 minutes! Cramer and the host were beyond words. Cramer made the comment that ”the machines have broken” by which he meant that the computers that drive trading and the ones that are supposed to somehow provide limits to downside risk such as this had failed, overwhelmed by the speed of orders and action. Deja vu all over again as Yogi Berra would have said back in the day. We were in a free fall and the bottom was anyone’s guess. Then suddenly it stopped and reversed course, reason unknown. This was the biggest intraday drop in the DJIA in history. 95% of the stocks in the S&P 500 were down, leaving the S&P Index at 1,066. And if you blinked, you might have missed it.

So is following Lynch’s advice to basically do nothing in the face of these fears, but hold on and hold out during these events the “right” thing to do? Or are you more of a mind to be proactive if you think a market pullback of any sort is coming in the near future for any reason at all? If being proactive is your frame of mind, what are your choices? What can you do to try and head off at least some of the eventual decline? Here’s a few ideas for those of you who may be newer to investing than others. Be advised: I am not recommending any of these approaches or ideas for anyone. I cannot say whether or not any of them will work to your benefit. The adoption of any/all is an individual decision that you must perform due diligence on before entering and decide if it could be suitable and appropriate for you.

1) Take a long position in the VIX Index – several options and variations on this are available. The VIX is an index that moves in reverse fashion to the general market. Market up, VIX down. Market down, VIX up. It can be very volatile, so be careful. But unlike options, it has no time restrictions – you can hold it for as long as you think prudent.

2) Sell call options on those equities you own. You collect some extra income from that premium, and if the market goes down (and your stock follows suit) you will in all likelihood keep the stock and have given yourself a reduced cost basis. But if you are wrong about a coming decline and the stock price rises above the strike price of the option before expiration you will in almost all cases have the stock taken from you at the call strike price. This means you gave up some of the appreciation that would have otherwise been yours.

3) Buy put options on your favored index or individual equities you own. If the market declines before the expiration date beyond the level of your strike price you will be able to “put” (sell) the stock to the seller at that higher strike price. But if the market stays relatively level or moves up you will lose the amount you paid to buy these puts when they expire (if you haven’t already closed the position by selling the puts).

4) Do a careful analysis of your long positions with special note being made of valuation criteria such as P/E ratios, P/B ratio, earnings growth rates, dividend growth rate and coverage, etc. If you think a position is well ahead of the historical levels you might expect to see in that issue, perhaps set a stop order on it so that, in the event of an overall decline, you will have some hope that you will be sold before the worst of the decline has happened. Be careful setting that stop price too close to the current bid price, however – legion in number are the investors that get a little too close to the flame and are burned when they get “whipsawed” out of a position. NOTE: caution here. A stop order without a limit acts only as a trigger for the brokerage to sell the stock. It is not a guarantee you will get that price, but you will be sold. And setting a limit on the price (a stop limit order) could mean no fill at all if the stock price gaps to the downside and there is stock ahead of your order to be sold. By the time your order has moved to the first position for execution, the price may have dropped below the limit and you won’t get executed. If you have any doubts whatsoever about that statement, consult with an experienced advisor for further information.

5) When you make a sale, let the cash accumulate uninvested in your account instead of immediately looking for the next place to invest it. Build a cash reserve so that if the decline hits, you’ll have some ability to take advantage of a few really good deals. I have personally been doing this as of late and plan to continue for awhile. If a correction of any significance is coming (did I say “If?” I should say “When”) I want to have some ability to make it a friend, not just an enemy.

6) Or you can just take the advice Lynch offered in that article 20 years ago. Don’t try to outguess it, don’t make any extreme moves, don’t in fact do much at all except accept the inevitable and let it play out, then be patient. It’s a historical fact that being out of the market for just a handful of the best days can and will totally wreck an investors overall returns. Not for nothing, but that is pretty much what Sir John Templeton might have advised as well.

Is a correction imminent? With the Dow currently near all time highs, a dozen different trigger events playing out as I type, and this Bull Market getting on to 5 years old, one has to wonder – are we running out of time? Is a serious correction looming on the horizon, or perhaps the start of a real Bear Market? Or did the correction in January provide a washout of sorts that leaves us with a lot of new room to run?

My friends, I wish I could tell you. I wish I knew someone who had that magic formula to apply to the markets and tell me. But I’m not that guy, nor do I know one. Perhaps you think you can tell us, and if so, by all means chime in with a comment. I’m always open to hearing new ideas and thoughts. Doesn’t mean I’ll agree or act on what I hear, but I like hearing it nonetheless.

What I am doing personally is much the same thing I’ll be doing starting in June as relates to those hurricanes I talked about at the start of this piece. I’m preparing myself as best I can by holding onto some cash in my accounts if and when it comes available. I’ve identified three solid companies with current realistic valuations, nice current dividends with plenty of earnings coverage, and in a business sector whose future appears bright. These three I watch, and if the day comes we have a correction of magnitude making these companies real, true bargains by crushing their price – undeservedly – along with all others, I’ll be ready to load up on them without having to think about it much. Speed is of the essence in those moments, and he who hesitates is lost.

And the most important part of the preparation has nothing to do with stocks. It has to do with my psyche, my attitude toward a correction / crash / bear market. Preparing myself mentally for it so that when it comes, I won’t panic and do something stupid. Ask any veteran about the importance of having your mind in the right place before going into battle. Or any sports professional. They’ll tell you that the game is played between the ears some times to a greater extent than on the field.

Are you prepared?

Until Later, the Blind Squirrel is signing off. May the best of investing fortune be yours!