Replacing Stock Laggards

Replacing Stock Laggards

Bear Market Recovery and Replacing Stock Laggards

By Dr. Winton Felt

When the recovery begins after a bear market, try to identify lagging stocks. Replacing stock laggards is extremely important because there has likely been a paradigm shift in market “psychology.” For one reason or another, you never sold when the sell signals were generated. You held your stocks throughout the bear market. When the market begins to recover, then, it would be to your advantage to screen for under-performers. Regardless of how wonderful a company is, the fundamental paradigm shift in market psychology that is common after a bear market can cause a stock to be ignored for an extremely long time. It is at times like this that we are often called upon to make uncomfortable decisions. For example, if we have a perfectly good stock that is going to be out of favor for three months, six months, or a year, do we hold on or do we switch while ours “takes a long nap?” The normal reaction to this question is “I’ll hold on because I do not want to realize a loss.” However, it’s not as simple as that. Suppose the stock doesn’t do much for a year, or even declines further, increasing your losses. The very best companies can have bad news, even after surviving a bear market. You could end up having to hold a stock for five years just to break even. The company may still be a great company, but its stock may not be particularly desirable in this market environment (after all, the market has just changed its psychology). Within the context of the new market psychology, another stock might be much more likely to recoup losses than the stock through which those losses occurred..

After a severe market decline, it takes time for the dust to settle and for indications to become apparent. Jumping prematurely one way or the other can be a very big mistake. With the passage of a few months, patterns begin to emerge. I think of it as analogous to a sea-storm. When the water is churning and being whipped by the wind, it is sometimes difficult to discern tides and currents. Once the storm subsides and the waters calm down, those tides and currents become more discernable. That is when it becomes possible to make use of those currents in plotting a course.

This is the time to watch sector recovery patterns. Each stock in your portfolio belongs to a sector or industry. Identify the sectors and industries represented by all your positions. For a comparative analysis, you can use sector ETFs or traditional sector mutual funds (we track a wide variety of ETFs, and Fidelity has a number of “Select” sector funds). Simply monitor the sectors and industries to which your stocks belong. Compare the charts of your stocks with those of their respective sectors. Look at the slope of the 50-day moving average for each position and sector. If the sectors to which your stocks belong are laggards relative to other sectors during the recovery after a bear market, then there has probably been a paradigm shift (assuming that your stocks were among the best performers before the bear market). Are any of your stocks moving sideways while their own sectors are rising? If so, those stocks are sell candidates. Is the angle of ascent of the 50-day moving average of any of your stock sectors less than that of the market’s index? If so, the stocks you have in those lagging sectors will probably lag the market. Any stocks you have in lagging sectors are sell candidates, and they are especially so if the stocks are also lagging their own sector or industry.

For example, a paradigm shift in the psychology of the market may result in a change in perspective regarding value as opposed to growth. This can result in a lessening of buying demand for certain technology securities. Investors may become very cautious about buying stocks that have the relatively high PE-ratios so common with technology stocks. The exact nature of such a paradigm shift often does not become clear for a few months after the decline has taken place and it becomes evident where the strong areas are. traders monitor an extensive list of ETFs (sectors, industries, investment styles, and indexes) and their strength rank relative to each other in order to keep on top of such paradigm shifts. However, they use a far more complex measurement of strength than the Relative Strength Index (RSI). They look for consistency in strength rather than a simple snapshot measurement based on 14 days. You could do something similar by taking three RSI measurements over three separate time periods and then combine the results. Then, you could rank the totals for all the stocks that you are monitoring.

Growth stocks often achieve a high PE-ratio relative to value stocks. The PE-ratio is the price of a share divided by the earnings per share, or the price investors are paying for each dollar of earnings generated by the company. Growth stocks may even continue to increase an already high PE-ratio over a period of several additional years. Thus, the fact that a growth stock has a PE-ratio of 50 does not mean it cannot go much higher. The PE-ratio goes up when the price of a share goes up. A stock with a PE-ratio of 50 could still double, resulting in a PE-ratio of 100.

When the PE-ratio of a stock keeps climbing, it may be because investors anticipate accelerated earnings far beyond present the level. That is, the PEG ratio may still be low even though the PE-ratio is high. However, other factors could also be in play. For example, it may be because investors think the price per sales or the price per sales growth rate is more important than earnings and these measurements far outstrip earnings or earnings growth. Alternatively, it may be because investors anticipate that a new product, service, or some technological breakthrough is going to change the way a stock is valued. That is, because investors may be looking at something other than present earnings, the price of a stock can go much higher than we might be able to justify on the basis of present earnings alone.

After the market “crashed” in March/April of 2000, a recovery period began in which investors, whether right or wrong, were reticent to invest in some of the stocks that were very popular (and moving up very strongly) just before the crash. There developed a new emphasis on buying stocks that were under-valued. That did not necessarily mean “value investing” was a better choice than “growth investing.” However, it did mean that a portion of the money flow began to be diverted to alternative areas in the market rather than returning to where it was before the crash. Some of the strongest stocks before the crash did get the share of money flow one would expect, but some others did not. When investor sentiment changed, investment capital began to be dispersed somewhat differently than before the crash.

The objective, then, is to determine which of your investments are likely to be left behind in the new market environment. Ask yourself whether replacing any stocks with other stocks might improve portfolio performance. Ignore “iffy” alternatives, where the prospects for a replacement stock are just as vague as the prospects for a current position. However, prudence does dictate that you at least consider opportunities that could improve performance in the new environment.

Of course you would not sell a stock if it is simply below your purchase price but recovering faster than the market as a whole. You might even conceivably decide that the best course is to hold all positions. However, tactically, it would be an error to stay in a bad situation just because of the pain you would incur (realizing a loss) by extricating yourself from a losing position. In reviewing the methodologies of the greatest investors of the last 100 years, I have become aware of one trait that is an almost universal characteristic. They had the necessary grit to close out a position even though they believed in it and even though it meant taking a substantial loss. In doing so, they set the stage for recovering the loss and then moving ahead. Some of these top investors have even said that it wasn’t until they learned to do this that they changed from being losers to being winners as investors.