Colorful Sine Wave

How to Succeed in a Sideways Market

At the time, my prediction that this year would be a sideways one for that markets was unpopular. It didn’t take long for sentiment to change once the market started drawing down in January. Today it feels like the “sideways” camp is pretty full. But off the heels of 2013, virtually the entire planet was very hyper-bullish about the prospects for this year and that seems like a distant memory now.

Here’s how the market has done this year:

SP April 2014

Up, down, meh.

The NASDAQ has been a slightly more dramatic story this year. The moves have been bigger, but the downtrend since the start of March is much more clearly pronounced.

Nasdaq-Apr2014

How long this environment persists is anybody’s guess. It could last a year or it could be over tomorrow.

Today we’re going to talk about some things you can do about it. The strategies we’ll discuss are awesome for sideways markets but they work pretty well in bull (or bear) markets too. They’re things you should be mindful of at all times.

How to Succeed in a Sideways Market

Sideways markets are deceptive and tricky things. They drive most investors bananas. But if you know how to navigate them, they really aren’t that bad. The problem is that they require a very different playbook. And they present two distinct challenges for investors.

The first is a challenge of psychology. Investors’ behavioral dysfunctions are really put to the test in sideways markets. Without a clearly established long- or medium-term trend to frame our basic feelings about the market, it’s much easier for investors to get swayed one way or the other. One day we feel great, the next day we’re panicked.

Take another look at that NASDAQ chart. Do you want to buy that or sell it? Where is it going? I don’t know??? 

What winds up happening is that when we’re feeling great and the market is up around its highs, we buy. When the market is down around its lows or we get a day like last Friday where there’s a quick dip that takes our breath away, we freeze up. Or we panic that it’s all over. That causes us to sell, or at the very least, avoid the market for the time being.

As you can imagine, this is a major problem in sideways markets where you need to be exposed to every bit of every rally to have a chance at pacing the market. We constantly buy high and sell low.

The second challenge is one of strategy.

In bull and bear markets, passive strategies work great. You just buy your stocks and hold on for the ride in a bull market. In bear markets, people are naturally afraid, and depending on the length and severity of the bear market, the passive strategy of avoidance can actually work out rather well.

None of that works in a sideways market, though. If you want to earn any sort of positive return in a sideways market, by definition, you have to employ some sort of active strategy. I realize that goes against mainstream wisdom for amateur investors. It’s not what Jack Bogle taught us. But don’t forget that mainstream wisdom is developed and dispensed during bull markets. That’s when investors are receptive. Investors go into a shell during bear markets. And they tune out, get frustrated, or fall asleep during sideways markets.

If you want your investments to go up when the rest of the market is going nowhere, you don’t have a choice. You have to do something different. You have to do something active. This is true by definition.

Passive strategies will earn you zero in a flat market, and worse, the longer they last, the more likely you’ll succumb to a mistake of psychology. Sometimes earning zero is OK. It’s certainly better than losing money. It’s better to just passively ride out a sideways market than make stupid behavioral mistakes by buying more during local peaks and heading for the hills when the markets sell off.

Some sideways markets are secular such as 1999-2012. Or the 1970’s. Some sideways markets play out over shorter windows such as 2011 or 2005. They’re virtually identical in the way they mystify investors and undermine their success, differing only in the time it takes their trickery to play out.

Loki

Here are some things you can do and should be aware of:

What you pay matters.

In today’s market, not every stock is priced the same way.

Benjamin Graham is famous for a lot of reasons, but perhaps most important was his concept of “margin of safety.” Without getting too technical about how we discount future cash flows and calculate fair value, “margin of safety” basically boils down to: buy good businesses for less than they’re worth.

If a stock is trading with a valuation of $1 billion, and you’ve determined that fair value for the company is $1 billion, there’s zero margin of safety. The reason why you want a margin of safety is because all sorts of things can go wrong. If you were wrong about the company’s cash flows or you failed to anticipate operational threats, fair value might be only $750 million.

If you only pay $750 million for a company you believe to be worth $1 billion, even if you get it wrong, you still break even. If it’s a good business, it should theoretically return to its $1 billion valuation and grow beyond that. That’s a move which will translate into nice profitability for you.

The returns you you get are a function of what you pay. Especially in sideways markets when there’s only so much growth to go around.

Quality matters.

I realize that the “quality” thesis might be a little long in tooth these days. In fact, almost as though they were anticipating a continuation of this secular sideways market, investors bid up the price of high quality companies. It’s substantially more difficult to find high quality companies trading a sensible prices than it was in, say, 2011.

If you’re going to pay a premium price, however, it may as well be on a quality name.

High quality companies are usually fairly easy to spot, even for the novice investor. They almost always feature strong brands — think Coca Cola, Disney, Apple, Nike, etc. Sometimes the brands are less widely known but still very strong within smaller sectors. If you stop a random person on the street corner, they might not be able to tell you who Oracle is or what they do. Not the way they would with those other companies. But Oracle is one of the most dominant brands in the world relative to their own market segment.

most recognized brands

Quality stocks also tend to generate tons of free cash flow. This is less obvious to the novice, and takes a bit of legwork to calculate. But more often than not, there’s a correlation between the power brands and whether the company actually does generate mountains of cash.

You probably guessed Coca Cola does pretty well, and it turns out they produce around $8 billion of free cash flow per year.

During sideways markets, these are the companies you want. It’s best if you can get them on the cheap, but it’s still better to pay fair value for a good business than get a good value on a fair business.

Valuations matter.

In a way, this is the same thing as not paying too much for an investment. But there are a variety of ways to value a business aside from discounting future cash flows. You can look at valuation ratios such as price/sales or price/earnings or something fancier like EV/EBITDA. They all do the same basic thing, though. They relate the current “price” of the company to some underlying fundamental metric.

When it comes to these, choose the ones that you like. Choose a couple or choose a bunch; use them together. Pick whatever makes the most sense to you.

For me, there are four that I use in conjunction with each other because they each tell me something very different.

  • Price/book (or price/tangible book) tells me how much a company is worth relative to its net assets, and by extension, it also tells me how much the market thinks a company’s actual business is worth. When a company trades at or around book value it’s the market’s way of telling you that either the assets aren’t worth what the company says they’re worth or that the actual business isn’t a very good one.
  • I very rarely use straight Price/Earnings because earnings can be lumpy and distort the picture. If you are going to use trailing earnings, either normalize them or relate them to the company’s own history. Don’t just use a straight P/E in a vacuum. I prefer price/forward earnings, as those tend to be more normalized, even if they’re subject to analyst error. Relating price to forward earnings also gives you a better idea of how a business is valued on a short term basis. It tells you how much you’re paying for the next year’s growth, and that’s a really important question for investors.
  • Price/Cash Flow (or P/FCF) is a good metric to use because it can tell you how long it’ll take to get “paid back” on your investment. If a company trades at 7 times (free) cash flow, that means that if you were able to buy the whole company today at that price, the cash flows the business generates would pay off your purchase in 7 years.
  • Lastly, I’m one of those wonks that likes EV/EBITDA. This is more of a longer-term valuation metric while the others tend to be more immediate. I like using Enterprise Value because it folds debt into the picture and every analyst worth his salt knows that EBITDA, though imperfect itself, is a better way to compare earnings and gauge financial health than net income. This metric originally came from the private equity and LBO world, and it’s a good way to figure out how much a business is worth if you don’t have a public market that’s already doing that for you.

You can use the ones that I do or you can use different ones. The point is that when markets start moving sideways, valuations start mattering a lot.

As an example, everybody freaked out last Friday when the Nasdaq had its worst 3-day drop since 2011. But I mentioned to our Alpine Advisor Pro subscribers that this has actually been going on for a while.

Growth vs. Value

 

Value beat the pants off growth last month. If we see more of this type environment, expect that trend to continue.

Contrary to popular belief, sideways markets aren’t actually the result of every company going sideways at the same time. In sideways markets, some stocks go up, and some go down. The ones that go down tend to be the ones that are too expensive across various valuation metrics. The ones that go up are the ones that are cheap. In some cases, the amount by which cheap stocks outperform expensive stocks can be extreme.  There’s a lot of historical data to support this.

Like I said: valuations matter.

Tactics matter.

I’ll be honest, I’m not a very good market tactician. In fact, I’m not a good tactician in any sense. It’s a general weakness of my personality and makeup, and it’s something I’ve been distinctly aware of since I was young. (In fact, this was one of those immensely valuable lessons that I learned by playing games.)

Since my brain just doesn’t work that way, I don’t try force it. I rely on the help of others here. This is where having skillful active managers can be very beneficial.

It’s hard to buy dips. It’s hard in a psychological sense because it feels scary to buy when the headlines are ugly and the tape is red. But it’s also harder than you’d think to spot where the dips are. If you can do this — and not everybody can — then this is one way to beat the market as it’s going nowhere.

It’s also hard to sell rallies. But in sideways markets, rallies are where you want to lighten up.

Not all trend-following is long-term, either. If you know how to spot little trends, you can ride them wherever they take you.

Solid tactics won’t guarantee you success in a sideways market, but doing a little better job at getting in or getting out can add up over time. In sideways markets, it doesn’t take much to differentiate yourself from everybody else.

Dividends matter.

Worried that the market will go nowhere for the next 2 years? With a portfolio of quality dividend stocks such as Intel or Altria or AT&T, it almost doesn’t matter. The effective yield of our Copper Canyon Dividend Income portfolio is just shy of 4% right now. Part of me doesn’t care if the market goes nowhere between now and the end of next year. We’ll still pocket close to 8%. That’s a very acceptable outcome and I sleep much better knowing we have that kind of cushion underneath us.

On top of that, this portfolio trades with a forward P/E of around 10x. It’s one that was constructed while being mindful of valuations as well. So it’s not like we’re paying a lot to get that yield. Most of these businesses also have pretty good margins of safety built into them.

I give this portfolio away for free. You can see what’s in it at any time. It’s right there in every weekly email we send out.

Email Snip - CC

 

If you’re not getting these emails, make sure you’re on the list. We’ve gone from around 1,000 email subscribers to over 1,300 subscribers in the last six months and this portfolio is part of the reason why.

I hate spam and I hate hypocrisy so I wouldn’t think of hitting you guys up more than once a week. We don’t sell your information out to anybody either because that sort of thing just isn’t cool. You can unsubscribe at any time.

Go ahead:



I should warn you however, this is not a very popular portfolio as currently configured. It contains some much-hated positions — some for social reasons like CXW and MO and others for technical reasons like AAPL and EDIV. I don’t care, though. These positions are all cheap, they generate tons of cash, and they pay out a large chunk of that cash to investors. If I wanted to win a portfolio beauty contest, I’d buy Tesla or something.

Whatever your tastes and preferences, know this: dividends dominate in sideways markets. In bull markets, they’ve historically accounted for around 20% of total returns. In sideways markets, they account for 90% of total returns.

Sometimes, beating the market while it’s going nowhere is simply a function of picking the companies that have good dividends.

Learn Options

Another way you can earn a market-beating return in a sideways market is by using options. Options sound weird and arcane, but these can be massively powerful tools for investors. Depending on the market climate and which options strategy you use, you can either enhance your returns or lower your risk. You can even make highly speculative bets with options, though I’m not personally fond of that. I’m a yield and risk-management kind of guy.

The easiest and most popular options strategy is writing covered calls. Ask any financial professional in the business and whether he actually uses the strategy or not, he’ll tell you it’s an awesome one to use in a sideways market.

Here’s an example from our Covered Call Screener (Option Sherpa subscription required).

Facebook - Options

Facebook is a volatile stock but the option premiums are awesome.

As of this writing (4/9) you can write options for next week and earn 1.56% between now and then. That’s an annualized return of 57%!

Here’s a less-spicy example that might more applicable for more investors. I mentioned Intel above and here’s what their options one month out look like.

INTC - Options

Wow.

You’re getting an annualized rate of return over 20% by covering Intel up every month.

You don’t have to write options right at the money, either. You can give yourself a cushion and participate in some of the gains if the stock goes up.

The 28 call options next month are annualizing around 10% right now. Those are around 4.2% out of the money. That means that Intel has to go up by more than 4.2% between now and May 17 before you start losing money on your option or you lose the stock.

Do you really think Intel will go up by more than 4.2% by next month? That’s a big move. Are you willing risk that Intel doesn’t go up by more than 4.2% every month in exchange for an extra 10% per year?

You’d better believe I am, especially in a sideways market!

Between the extra 10%/yr I can earn from the options market in a relatively conservative manner and the 3.5% dividend that Intel is currently paying me, I couldn’t possibly care less if the market went nowhere for a while. In fact, I’d sorta prefer it to.

Even if the market goes down this year, I’ve still got 13.5% of cushion before my portfolio actually starts losing money.

Anyway, if you learn how to use options, sideways (and bear) markets are substantially less scary. My colleague Kyle, the Option Sherpa, teaches people how to do this. He runs three different model portfolios and tells you exactly what to buy and when. He’s on his way to creating a wealth of educational content over on YouTube.

Check it out or send him a message.

He even manages this stuff professionally for investors who don’t have the time to do it themselves. (As long as they’re accredited.)

If you want to learn more on your own, my friend Ken Roberts wrote a nice little book about options. He talks about all the different things you can do with options and which strategies work in which markets. Give it a look:

I realize I’m sorta talking my book here with this stuff, but whether you use our service, somebody else’s, or just do it on your own, options are a time-tested, proven strategy to help investors deal with difficult markets.

Discipline Matters

Discipline technically falls into the realm of psychology but it’s worth highlighting on its own, especially after everything we just discussed.

The point is that none of these things matter if you don’t stick to them. If you don’t have the discipline to be mindful of the price you pay for things and aren’t disciplined about sticking to higher quality and aren’t disciplined about the tactics you use and writing your options every month, none of this matters. It’s all academic.

You can be the best fundamental analyst in the world or the best options trader, but it doesn’t mean a thing unless you have the discipline to actually do it.

In bull markets, riding along takes very little discipline. So does staying away during bear markets. You can do those things almost without effort.

Sideways markets take more work. I know that’s not what you wanted to hear, but it’s the unfortunate reality.

These are environments where the most disciplined investors are always the ones who excel.