What to do when the market turns nasty

Could you have foreseen the spread of COVID-19 back in January this year and the impact it would have on the market? I, for one, could not. In fact, I haven’t met anyone who clearly saw the disaster coming. It was a totally unpredictable event.

There were warnings of a pandemic. Bill Gates briefed US President Donald Trump back in 2016 about that very likelihood. But did anyone really take any notice? Is it not fair to say that a pandemic is always a threat and the possibility is always out there, along with fires, floods, earthquakes and the like?

The key is to know when such an event is likely to take place and prepare accordingly.

Unless you are watching every news item closely and constantly living your life in anticipation of the next market disruption, how do you protect your portfolios for an unforeseen market disruption? 

One way I like to keep my portfolio safe is to look at what my stocks’ earnings are doing. Companies that are growing their earnings, year in and year out, are companies that are more likely to weather storms and give me more time to move to the sidelines, if required. Take for example Northern Star Resources:

The blue area line represents the earnings for Northern Star Resources. Rising earnings, rising share price. Now if an unforeseen event takes place, would you rather have a set of shares in your portfolio with rising earnings or a set of stocks with falling earnings?

Case in point, look at the earnings profile for Reece Ltd.

Over the years, we have seen time and time again, companies with falling earnings result in falling share prices.

A lot of share investors note: “I do not want to sell my stocks as I need the dividends and franking credits.” At VectorVest, we never advocate a buy, hold and hope-type strategy. Such a strategy can result in significant losses. However, we do appreciate the need for retirees to earn dividends and franking credits.

As such, which types of companies will typically pay consistent dividends? Are these companies earning more and more money each year, or are they losing more and more money each year? A rhetorical question, right? 

We want to back companies that have a track record of making more money each year. In addition, we would no doubt like companies that are paying more and more dividends each year.

Finally, our last key requirement is to find companies that are growing their earnings each year, because they are likely to be companies growing their dividends and share prices.

Take the example of National Australia Bank. For many months now, its earnings profile has deteriorated. As a result, the dividends were cut. This is a pattern that plays out time and time again

What other proactive measures could we have taken to protect ourselves in an uncertain market? Here are three additional measures:

Apply ‘stop losses’
But, you say, stop losses will potentially sell my shares and I will not get my dividends. Yes, that could happen, but what if your stock drops by more than your dividends? Then you will have lost more than you made.

Chances are, without stop losses, you will lose significantly more than you will make from dividend and franking credits. Once your stop loss is triggered, and you sell out, you can always buy back in. Think of this as having the option to buy in at a lower price to be in the running for those great dividends you’re after.

Buy ‘puts’
Buying a ‘put’ entails buying an option, that being a ‘put option’. At this point, most people look uncomfortable. You may be thinking, “options are super risky, and I am not interested in options”. Do not let the negative media articles on options distract you. Yes, plenty of options trades can be highly risky. Too many investors out there take the get rich quick type of options trades that invariably end badly, and these stories are the ones you typically read about. However, if used correctly, options can protect your portfolio. 

A put option can be compared to buying insurance. No-one likes to pay their insurance premiums, but when something bad happens and we are insured, we are pleased to have it.

A put contract gives you the right, not the obligation, to sell your shares at a certain price at a certain time. One contract controls 100 shares. If you own 100 BHP shares, for example, and you were concerned the price could fall in the near future but you wanted to hold on to BHP to receive your dividends, you could consider buying one put contract on BHP.

Put contracts go up in price as the price of a given stock (e.g. BHP) goes down in value. The contract becomes more valuable the lower the price falls on BHP. You can, of course, buy more than one contract. And no, buying a put contract does not mean you have to sell your shares, you simply sell your put contracts to another buyer.

Buy inverse or contra-ETFs
Contra exchange-traded funds (ETFs) are designed to perform the inverse to what the market is doing. For example, BEAR is a listed ETF on the Australian market. It is designed to seek returns that are negatively correlated to the ASX 200 index. As the ASX 200 index falls, BEAR is set up to benefit from this and rise in price.

Investors can consider inverse ETFs in their portfolios to soften the impact of falling markets. As the market rallies, the inverse ETFs, by nature, typically do not perform well. So this may be a strategy you only consider in a bear market. Two other inverse ETFs you may consider for the Australian market are BBUS and BBOZ.

Go to cash
Cash is a position. It is not ideal if you are after dividends and franking credits. But again, one must weigh up the possibility of losses exceeding dividend yields. 

Although I was unable to give you insight on how to identify the next unforeseen market disruption, I was able to show you how to correctly analyse and prepare your portfolio. You should note whether your share earnings are rising, ensure you have stop losses in place, and consider inverse ETFs or cash as a position for the next downturn.

Russell Markham has more than 22 years’ commercial experience in financial analysis, marketing, education and training and, at VectorVest, has been helping retirees with stock selection and trading plan optimisation for the past 10 years.

Are you an eagle-eyed investor who closely follows the market? Do you understand such terms as ‘puts’ and ‘stop losses’?

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Disclaimer: All content in the Retirement Affordability Index™ is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.

Written by Russell Markham

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