Ming Lo Investing

Best Practices: Managing the Portfolio through a Correction

Posted by admin on June 2, 2010  |  No Comments

Just a contextual note: best practices are a constant work-in-progress.  So this column is not meant to be definitive by any means.  It’s basically a set of ideas of how to do things better next time.  And of course, that’s always evolving.  So no holy grails here, just ideas on how to improve over time. Handling a correction is always of interest to me.  So these thoughts are based on the correction of May, 2010.

Preparation. One of the keys is being prepared beforehand.  You can never be 100% sure of things, but some basic steps can give you working parameters and mitigate the “freeze” or “panic” caused by swift and sometimes brutal corrections.  Here’s some ideas:

• Consider a range of outcomes. I did call for a correction at the beginning of May 2010, but frankly, I didn’t expect it to be as severe as it was.  My clients were 30% or so cash, and as the correction went on, I took them to 40-60% cash.  Most would consider that pretty good, but in retrospect it wouldn’t have hurt to sell out of most positions, since almost everything went down.  One step for next time: spend more time thinking about outcomes that are less likely.  Then, you’re more prepared to pull the trigger on selling if you have to.

• Quantify the correction – 5-8%?  10-15%?  or 15-20%?.  Here’s a simple back-of-the-envelope calculation: the April 2010 S&P high of about 1220 divided by the March 2009 low of 666 is about an 83% gain in the markets.  From that perspective, a 15-20% correction is not unreasonable.  So far, we’ve had a 15% correction, as of June 2, 2010.  If anything, this back-of-the-envelope implies there might be more to go, because a 15% drop is small compared to a 83% rise.  Perhaps not immediately, but if the market falls further in the next six months, it shouldn’t be a surprise.  Of course, analysts came out and said a 15% correction was normal, after the 15% occurred.

• Be aware of “analysis paralysis”.  One of the most common things that happens during a correction is “analysis paralysis” – you look at a stock and you say, valuation is cheap.  In fact, Tim Seymour on Fast Money had a great phrase – “stupid cheap”.  Yet during the lowest lows of this correction, no one bought, because everyone acknowledged that things could go down further.  During the May 2010 correction, the “analysis paralysis” was made worse by the Flash Crash – stocks reached levels that were ridiculous in a matter of minutes.  For a moment, everyone said this was just a computer glitch.  But then the market traded down below the levels of the Flash Crash a couple weeks later.  In retrospect, it made sense that the market would want to re-test the Flash Crash low; perhaps re-testing the low and re-bounding off that low is the only way to make sure it was behind us.  By the way, so far we’ve tested the Flash Crash low as well as the low of the prior correction in February.  As of June 2, 2010, the jury is still out on whether we’ve bottomed (in my opinion).

Managing A Portfolio Through a Correction. One of the hardest things about a correction is the sense of not knowing where things are headed, and having no reference points to work with (because by definition, a correction re-sets all your reference points).  But, I think there are a few rules of thumb that might help.

• Know that recovery time is proportional to damage done.  To be fair, I’ve only done anecdotal research on this, but it seems to make sense (especially in retrospect!).  Over the last year, we’ve had several pullbacks of 3% which only lasted days.  The February 2010 correction was about 9%, and it took 13 sessions to go from the high on the S&P of 1,150.45 on January 19, 2010 to the intraday low of 1,044.45 on February 5, 2010.  So far during the May 2010 correction, it’s taken us 21 sessions to go from the intraday high of 1,219.80 on February 26, 2010 to the intraday low of 1,040.78 on May 25, 2010.  And if you do the math, that’s ~15% in 21 sessions.  I think this is tremendously useful, because within the first week of a severe correction like the one in May, you’ll be saying to yourself, “Well, prices are really low (relative to where they were), should I buy some?” And the answer, if there’s lots of damage, is no.  Wait a couple weeks, even if that implies prices will be ridiculously low.

• Expect several drops and bounces before any uptrend can be established. Take a look at the following chart of the February and the May correction. In February, you’ll see at least three sets of red, 2-3 days of declines each time, before the market touches the 150-day moving average and reverses.  In May, you see three sets of red as well. We don’t know if the market has reversed yet, so there could be more, but the point is this: don’t buy the first, second, or perhaps even the third bounce.  It’s impossible to know how many bounces there will be, but expect the market to work its course.

• Do not confuse catalysts with fundamentals. Corrections can be very confusing because there are so many factors at work it’s hard to decide which ones to pay attention to.  To make matters worse, the media will focus on the catalysts, the economists will get on CNBC and say that the fundamentals aren’t that bad, and NO ONE will talk about the real long-term causes.  Let’s look at two examples from the May correction.  First, on Friday, April 16, the SEC charged Goldman with civil fraud.  This shocked markets, causing the S&P to drop nearly 20 points (a lot for the S&P).  It was such a shock that we all got caught up in case – whether the SEC had a case; whether Goldman actually did anything wrong; what the damage might be to Goldman; the dramatic day of hearings in Washington; and so forth.  I’m sure there were also fears that Washington was going after the fragile banking sector, which would certainly be cause for alarm.  But lost in all this was the fact that almost everyone would agree that the market was frothy (given an 81% rise of the March 2009 low at that point) and that a correction would make sense.  Second, take the S&P downgrade of Greece to junk and the eventual European $1 trillion bailout package.  When this occurred, the fear was contagion.  Still, many analysts and economists jumped on television, saying that these debt problems might only knock 1% off European GDP.  Even more were saying that the bailout package was exactly what was needed, and a rally ensued the Monday after the bailout was announced over the weekend.  Frankly, I did some buying on that Monday, based on the belief that fundamentally, we weren’t in situation similar to October 2008, and that the selling was overdone.  In retrospect, that was a mistake.  Of course, that rally was short-lived, and the market continued to fall.  I do think that the economists are right in the long term – but the market, at that time, didn’t really care.  I think it’s reasonable to argue that the market wanted a correction – and make that a significant correction, and the reason or the catalyst wasn’t really relevant. That’s important, because it makes the “solution” to the crisis – the $1 trillion bailout package – equally irrelevant, so trading on the “solution” was a mistake. Many will say that even with the bailout package,  there were concerns about execution and contagion.  Still, if you think about it, we’re not anyway near declaring execution a failure or contagion a certainty.  Part of the correction was fear and over-reaction; but maybe, part of it was that the market needed a correction to feel better and move forward. To stretch this just a bit further, think of it like some relationships – sometimes you need to have an argument to move forward, and the reason doesn’t really matter.