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Investment Strategy

Why We’re Worried about Stocks

By Elliott H. Gue, on Oct. 20, 2015

You can’t fight the business cycle. Economic booms, busts and panics have occurred since the dawn of recorded history, regardless of the actions taken by governments and central banks.

However, investors who understand how these cycles work and make the necessary adjustments can take advantage of these inevitable downturns. Recognizing and responding to the economic cycles distinguish the investment world’s outperformers from the also-rans.

The financial infotainment industry usually emphasizes stories about stocks that have outperformed or are expected to outperform the broader market.

Here’s the rest of the story: Many of the most successful investors don’t necessarily pick the best stocks to buy during a raging bull market; however, these winners have proved adept at avoiding some of the pain associated with bear markets and economic downturns.

Consider Sir John Templeton, who launched Templeton Growth (TEPLX) in 1954. Those who invested $10,000 in this mutual fund when it debuted would have grown their principal to more than $1.7 billion by 1992, when its founder relinquished his management duties.

Templeton Growth outperformed the Morgan Stanley International World Stock Index by an astounding, annualized rate of 3.7 percent—an impressive track record during a tumultuous period of market history.

The famed fund manager was a proponent of the Yale method, which involves reducing allocations to equities when valuations reach historically elevated levels and rotating into bonds and cash equivalents.

This discipline meant that Templeton Growth allocated about 63 percent of its investable assets to equities in 1969—a positioning that enabled the fund to outperform many of its peers significantly between 1970 and 1976, when the S&P 500 posted an annualized return of 3.2 percent.

Over the preceding 15 years, Templeton Growth lagged the market slightly; the mutual fund’s relative outperformance during the vicious bear markets of the 1970s made a huge contribution to its long-term outperformance.

According to Templeton’s Way with Money: Strategies and Philosophies of a Legendary Investor, Templeton Growth generated an average total return of 147.5 percent in every bull market from 1954 to 1990. By comparison, the MSCI World Index posted an average total return of 139.9 percent over the same holding periods.

However, the fund’s average loss of 12.1 percent during bear markets easily bests the MSCI World Index’s average loss of 21.9 percent.

Warren Buffett has asserted that “forever” is his preferred holding period for stocks, but the sage of Omaha also pays attention to the business cycle when choosing his entry points.

On Oct. 16, 2008, the New York Times published an op-ed piece penned by Buffett, entitled “Buy American. I Am.”

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Investors who followed Buffett’s lead and bought large-cap US stocks in October 2008 didn’t catch the market’s exact bottom; the S&P 500 tumbled another 27 percent before reaching its nadir in March 2009. Nevertheless, those who invested in the S&P 500 the day the New York Times ran Buffett’s famous op-ed would have earned an annualized total return of 15.8 percent.

Successfully managing your portfolio through the business cycle doesn’t require you to time the peaks and troughs for specific stocks, sectors or the market as a whole. Investors must pay attention to company-specific developments and monitor the health of the market and economy to identify periods of elevated risk.

At these times, investors should exit weaker names, take some profits off the table in cyclical winners and add hedges to offset some of the losses your equities would suffer in the event of a market downturn.

Cash raised in the waning stages of a bull market, coupled with profits generated by hedges, gives you a store of dry powder with which you can scale into high-quality stocks at discounted prices.

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