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Five More Ways to Handle Market Stress

Scott Rothbort

As I wrote in "Seven Ways to Handle Market Stress," "We will have many losing days, some 'down' months and an occasional 'off' year. What you need to do is keep focused on your long-term objectives while managing risk in the short-term. Remember, had you bought the [S&P 500] on the day before the 1987 market crash, your cumulative return through the end of July 2007 -- without dividends -- would be 415%. That is even after giving up 20% on the first day after your investment."

The S&P 500 has declined in 15 of the 58 years since 1950. That is a little more than 25% of the time. The average decline in those years was 12.21%. There is no telling which years will be down. Sometimes you can predict it and sometimes you can't. However, remember that from 1950 to 2007 the simple average annual return for the S&P 500 was +9.26%. That includes up years, down years, bull markets and bear markets.

So here are five more ways to cope with and interpret market volatality.

1. Understand This: You Are Not Alone

The current market is not a market that's conducive to growth and/or value investors. To give some perspective, let me list some household investment names and their year-to-date (YTD) returns:

*Calculated by LakeView Asset Management

**Source: Morningstar

I will also note that the S&P 500 has fallen 14.94% this year. (Note: All figures are YTD through the close of Sept. 11, 2008.)

If your current investment portfolio return is similar to the returns of the money managers listed above, then you're in good company.

Personally, I count myself as a value and growth oriented investor, rather than a "trader" or "technician," and will admit that this has been a poor year for my performance vs. some outstanding years in the past.

I will guarantee you that the managers listed are not closing up shop (see No. 4 below). Please note that they are all long-term investors and not short-term traders. Ask yourself this question: Would you fire any of them just because they are having a bad year? I wouldn't.

2. Make Necessary Tweaks

Those all-star investors mentioned above are not sitting idly by. As growth and value investors they will be looking for opportunities and will be restructuring their portfolios during these times. Most are primarily long only and some have limited short capabilities. They know that bear markets turn into bull markets and that patience will be rewarded.

Here are some recent investment tweaks that I have made.

I was long Amylin Pharmaceuticals (AMLN Quote) for some time. Some of my purchases were at lower prices, while some were higher. The stock has run into a recent issue with deaths linked to the company's Byetta diabetes drug. The Byetta LAR formulation, an event that I was awaiting, has been delayed further into the future and may be in danger of not even occurring at all. Bottom line: I sold my Amylin.

On the other hand, I have become more aggressive (since late July) in the restaurant and food services sector. In my opinion, the domestic economy will improve and commodity prices for energy and food have topped in this current commodity cycle. So, over the past several weeks, I have bought names like Yum Brands (YUM Quote), Panera Bread (PNRA Quote), Dr. Pepper Snapple (DPS Quote) and Darden (DRI Quote).

While I see timely value in this sector, please note that after a huge run, I recently sold my Buffalo Wild Wings (BWLD Quote).

3. Know Thyself -- As an Investor

Following up on point one, if you are a growth or value investor (or a hybrid of both), don't change your investment style just because the technicians are telling you that "the charts are breaking down."

I am not here to belittle technical analysts. However, I think the divergence between value analysis and technical analysis can be summed up by Warren Buffett, who is quoted as saying, "If a business does well, the stock eventually follows" and "if past history was all there was to the game, the richest people would be librarians."

Technicians would say that a stock's price history will dictate future stock movements. Clearly there is a clash of these two styles. Both cannot always work at the same time. When they do work together it is a moment of trading and investing ecstasy. However, if you switch styles now, you might find yourself in another predicament when your old style works after you've abandoned it.

4. Don't Let Hedge Fund Madness Distract You

Take a look at what happened to Ospraie Management. The Ospraie Fund, which had $2.8 billion at the beginning of August, lost a reported 26.7% of its value during that month in the wake of a "substantial sell-off" in energy, mining and resource equity stocks. There's no doubt in my mind that Ospraie was highly leveraged and controlled a far greater amount than $2.8 billion of equities. Now they are liquidating and closing the fund. Ospraie is not alone.

Hedge fund managers are closing their funds en masse because they will not earn their performance fees, which typically are 20% of a fund's profits. (Don't miss: "Hedge Funds and You: What Individual Investors Need to Know") In a few years, many of these managers will open up a new fund with a similar investment format, thus wiping out their performance deficit and starting from a zero performance benchmark.

A prime example is John Meriwether, who after blowing up Long-Term Capital in 1998 started JWM Partners in 1999. (The latter fund has lost a sizeable percentage of its assets this year.)

The collateral damage caused by this systemic liquidation in the hedge fund industry is tremendous. When in liquidation mode, the primary focus is on selling at any price, not what price. Valuation and performance go out the door.

So who suffers? In the short run, it is the value and growth investors who see their investments being whipsawed without rational explanation. When your stock falls 10% in one day, you have to ask yourself if it's really worth 10% less or whether a leveraged liquidation is taking place without concern for price.

Again, if your investment bias and mandate is value and/or growth, then follow the advice of those investment managers who focus on value and/or growth. Become less concerned about short-term movements and stick to your long-term investment approach, with the full knowledge that the markets and your investments will not rise each and every year.

5. Don't Be a Chicken Little

When times are good the commentary in the media and elsewhere is positive. When times are bad we get the mirror image of that commentary, namely that "the world as we know it is coming to an end." Listening to either type of extreme commentary will lead you to become too ebullient during bull markets and too demoralized during bear markets.

Bear Stearns is gone (JPM Quote) and for all intents and purposes, Fannie Mae (FNM Quote) and Freddie Mac (FRE Quote) are now bankrupt. Calls for a market crash and global depression are gaining popularity. But we will survive. If you don't think so, then research the lessons learned from the demise of Continental Illinois, Kidder Peabody, Drexel Burnham and Long-Term Capital.

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