Stock Talk #5: Ignoring the “When Is the Bottom?” Question

Stock talk note: I’m planning to do a longer and more technical research post on $CHEF later this week, as well as post the list of names I’ve been looking at based on some improvements I made in my screening tools. Today’s post is about general market strategies, so feel free to skip if you’re here for picks.

Starting this stock talk off by getting a little higher level on what seems to be everyone’s favorite market topic – whether stocks are headed up or down *right now*. A focus of CNBC frequently is if we’ve seen a bottom in the major indices. I want to be very clear now in saying this question is irrelevant for the long-term investor.

What I’ve found usually gets this discussion going is huge moves up in stocks like we had yesterday. When these moves happen, this question always comes up:

What if I miss the 30%+ up moves?

One thing that’s been evident this crisis is that many small cap and even large cap stocks are moving a year’s worth of returns in a single day. What’s important to remember here is that many of these stocks lost 50-75% of their value from peak-to-trough. Let’s look at a 50% up-move in the context of that (and apologies to those of you who have walked through this math – I think even so this is useful as a reminder):

1. Stock peaks at 100, drops 75% to 25 over the course of four weeks
2. Stock goes up 50%, now at 37.5 in a single day, but still down 63% from peak
3. Stock goes up 50%, now at 56.25, still down 43.75% from peak 
4. Stock goes up 50%, now at 84.375, still down 15.625% from peak
5. Stock goes up 18.5%, now at 100, back to even

Said another way, a 75% drop requires three 50% up days and an 18.5% up day to get back to even. The massive one day moves in stocks we’re seeing don’t get people anywhere close to whole and shouldn’t be seen as “bad” entry points. In fact, if you assume it will take four years to get back to even (which is a super bear case scenario, but one I’m using here for illustration), let’s look at the annualized returns for each:

1. Enter at 25 – when stock gets back to even, 15% annualized return
2. Enter at 37.5 – when stock gets back to even, 13% annualized return
3. Enter at 56.25 – when stock gets back to even, 9.5% annualized return
4. Enter at 84.375 – when stock gets back to even, 3.7% annualized return

Here’s a full table showing sensitivities for 4, 3, 2 and 1 year to get back to the top. Consider how long you think the market will take to get back to even post Coronavirus when looking at this. For stocks I hold, I would be overjoyed with a 7%+ annual return, so I’ve highlighted those in green:
I think this chart is worth a thousand words. Even if you buy a previously $100 stock that is now $85 or less (AAPL – down 20%+, BAC – down 38%+, SPY – down 21%+), you are looking at a nearly 8% annualized return if the market recovers in two years. Even in the bear case four year scenario, a 3.7% return is far preferable to treasuries or bond like investments, and this is only for stocks 15.6% off highs. For investors who think this market won’t recover for half a decade, there are stocks that can be bought right now for double digit returns if you assume we can get back to the 2020 high.

Then how do you decide what is a good entry point and how much to buy?

Far more complicated and perhaps better strategies exist than what I use, but my three guiding principles for timing and allocations are 1) dollar cost averaging, 2) the Kelly criterion and 3) rebalancing based on judgment calls.

Dollar cost averaging (DCA)

I think this one is fairly well known; buy some set amount or amount in range on a repeating time interval (ex. on the first of every month, buy $X of stock). By doing this, you’re increasing the probability that your “average” purchase price is reflective of a stock’s trading range over a long period of time, versus trying to time the market with one fire of a bazooka. Ben Carlson has a great post on this.

The Kelly criterion

The Kelly criterion says that the maximum amount you bet relative to your payroll should be your advantage in a given bet dividend by what the bet pays out. As a simple example, if you believe you have a 10% advantage over the market on a given bet and it pays out 10:1, you should bet 1% of your bankroll (0.1/10). The basic idea is that 1) bankroll growth is dependent on not going bust and 2) that it’s hard to compound if you have large swings down (because compounding assumes a frequently growing base of wealth to take a percentage off). Fortune’s Formula is an awesome book that walks through some real world examples.

Importantly, I don’t really have a hard and fast Kelly-criterion based rule for stocks (I do for sports gambling – that’s another story), but I like to think about it when considering position sizing. The math behind the Kelly criterion is a reminder to stop yourself before oversizing a position. Some bettors even follow a “half-Kelly criterion” that takes the number Kelly spits out and divides it in half. TL;DR – it is difficult to come back from an initially sized 30% of your portfolio plus sized position that goes to zero; a risk-on 2-5% position is not ruinous and can potentially grow to 30% of your portfolio… which brings me to my next point.

Rebalancing

When good positions outperform your bad ones, they become a larger portion of your portfolio. As a result, your portfolio’s risk and expected performance in different environments change a ton over time. For me, this has been most evident in the growth of GLD (gold ETF) as a percentage of my portfolio. If I expect stocks to outperform gold over the next five years (which I do now), I need to sell gold and re-allocate to stocks. The percentages involved in this re-allocation depends on the investor and his or her preferences for expected returns, volatility, etc. There is a ton of literature on rebalancing and I don’t have a silver bullet other than to say I think it should happen on some set duration (just like dollar cost averaging).

My point here is that now is a great time to buy for stocks 15%+ off the highs if you assume we get back to the highs in four years or less. Yes, we can and will probably go lower, but I have no issues having a percentage of my portfolio at a 7% expected annualized return instead of 14%. Now is a great time to buy if you have a four year or more time horizon (and even shorter is good). Questions about when the bottom are miss the forest for the trees.

Happy trading,
Brostoff