Preparing for Crashing Markets

I was surfing around seekingalpha.com the other day and I happen to stubble upon a very interesting article by Tim Ayles entitled "Preparing for Crashing Markets".  Mr. Ayles addresses the facts and the reality of a huge bubble that is to come because of the Fed and federal government's involvement in the markets.  Most importantly he addresses how you could position yourself favorable to with stand a bubble burst.

I thought this article needed to be heard more widely, as it is a serious problem.  It is the kind generosity of Mr. Ayles that I was given the privilege to republish his article on Invest Chief.  Please visit the "about the author" section at the bottom of this post.

Preparing for Crashing Markets (by: Tim Ayles)

If the Fed and government continue to meddle in the free markets in an attempt to prop up asset prices at levels that are "higher than they otherwise should be", you can be certain more bubbles and asset price crashes are ahead. I would say chances are about as good as the sun rising tomorrow.

Black Swan type events of bubbles crashing are beginning to happen closer in time than they ever have before. It creates the sense that things are quickly spinning out of control, leaving investors ever more skeptical and afraid of the future. These investors may forever pull their money from the stock market they increasingly feel is manipulated, and are more concerned with the return of their principal than a return on their principal. They do so risking their long term ability to not run out of money before they die.

Pragcap.com has done a good job in covering the aftermath of bubbles in the past. In this article, I want to present the case that the typical investor is not mentally prepared for a market rout, and then provide solutions for the way one invests as a means to overcome the panic that is sure to set in for most human investors during market crashes.

This chart is the anatomy of a typical bubble. You can see the different responses of different investor types as the bubbles take off and then crash. After the initial drop in prices following the mania phase, most investors think that they are faced with a great buying opportunity. As the market goes up from that dip, the idea of them being right is reinforced and they are left complacent in their regards for the risk they are taking. When the market turns back down and begins to crash, most investors are frozen expecting a bounce back to get them back to break even, where they promise God in their prayers that they will get out. As the market continues to plunge, they get to a point where they think the world is falling apart, and that they want to just save some of what they had, vowing to keep that money safe and promising to never return to the market. Right when they throw in the towel, the low is reached, and the market begins the next cycle of parting investors with their money.

I propose the reason that most people throw in the towel at the lows is that they view their investments completely wrong. The stock market to them is no different than a casino. They do not view the stock market as an easy way to own pieces of actual businesses that pay them actual profits from selling actual products. Price gains are all they focus on. The problem with price gains is that it IS gambling. Let me show you.

You can do all the research in the world on a stock. You can know the company's products, balance sheets, income statements, customers, management teams, etc. You do the due diligence and figure you are ready to buy at a certain price you feel is a great value. The moment you buy, you are now at the mercy of the market. You no longer have any control. The only control over your investment that you have is how much you are willing to risk, and when you decide to get out. As far as the direction of the price of the stock, you have zero control. Gains will be decided by the market as a whole. If those around you are scared, you will lose money. If they are euphoric, you stand to gain. Your wealth is not at the mercy of your friends and neighbors emotional state. The original buy price that you paid is basically your line in the sand. The company can grow is revenues and income, but if others aren't willing to pay a higher price than your "line in the sand" price, you don't make a dime. For those of you who think that a business who is increasing in value from higher earnings will have an ever rising stock price, you must have been asleep the past 11 years. Many companies have doubled and tripled their earnings the past decade, yet they have not seen their share prices go higher.

This is also a problem with the majority of mutual funds out there. Most mutual funds track the prices of stocks, and therefore have their own line in the sand number if you buy them. If you are retired and have been relying on these mutual fund share prices going up the past decade, you are running out of money.

This share price "line in the sand" mentality is what creates fear and panic at market lows and the eventual throwing in of the towel. If you buy a mutual fund at $30 per share, and hold it all the way down to $15 per share for a 50% loss, you probably lose heart. During those types of crashes, the news flow about the market and economy are terrible, thus reinforcing your fear. Based on what you hear, you are certain the stock market will languish for decades. You realize it will take years for your mutual fund to gain 100% from $15 per share just to get back to break even. You begin to rationalize being safe and selling at $15 per share because 50% of something is better than 100% of nothing. You don't want to see this thing go down to $5 per share, so you cash out.

If you are reading this and never felt this way or have never done something like this, your name is Warren Buffett. Everyone else reading this probably has a story that is similar.

Now for the solution. How can an investor retrain the way they think and invest so that when the next bubble does explode, they will not sell at or near the lows, only to watch the investment go higher without them?

Simple. Buy stocks of companies that sell products that people have to buy, creating large free cash flows, and have managements in place that want to pay the investors an income. By buying stocks that sell products people have to buy, you will create a first line of defense mentally in that you know the companies you own will probably not be out of business. If you buy Kraft Foods (KFT) for example and the stock drops 50%, you probably won't sell it out of fear they are going out of business. People will still eat food if the S&P 500 drops to 600.

More importantly, make sure any company you buy is paying a dividend that is more than covered by a healthy Free Cash Flow. Let's take a look at an example.

Verizon Communications (VZ) currently has a $92 billion market cap selling products that even homeless people at food shelters can somehow afford. Sporting a current yield that stands at 6%, the stock is more appealing than most bonds that I could buy today. Last year VZ paid out $5.2 billion in income to its shareholders through dividends, while bringing in $14 billion in free cash flow, meaning they had almost $9 billion more they could have paid out for dividends! In 2008 they made about $9 billion in free cash flow, almost double the $5 billion they paid out. As you can see, Verizon has plenty of money to pay out. Through the September quarter 2010, they have made $13 billion in free cash flow, having paid out about $4 billion in dividends.

So how will a company like Verizon help you not sell near the bottom? Well, I would argue that when you own a company like Verizon who pays a current 6% yield, and has no problem affording that kind of yield, it will be very hard to sell it if it drops 50% from here. If you invest $10,000 in VZ now and get a $600 per year for income, if the stock price drops to where your investment is worth only $5,000, although sad, you will be less likely to liquidate that $5000 and turn it into cash when the $5000 is currently paying you a 12% return ($600 on $5000 is 12%). Even with your line in the sand price 100% higher after the 50% drop, the solid dividend begins to force you to not do something stupid, like sell at the lows. At that point - you really can't get a much better deal than 12% on the money if you were to sell. Are you going to get rid of the $600 cash flow and put it in the bank to earn $12.50 a year? If your investment languished at a $5000 value for years, you at least get to earn $600 per year which you can go and spend on life's essentials you need. If you had $10,000 in a mutual fund that turned into $5000, you don't have the same luxury. To get the same same $600 for life essentials, you would have to sell $600 worth of your shares that are worth 50% less. If the market doesn't rally quick, you run out of money in 8 years. As we like to say at the office: "That's no bueno."

Some of you might be thinking, if the market dropped 50%, then the economy is doing badly and VZ is probably losing sales and seeing their earnings drop. To which I would reply, what if half the people in America got rid of their cell phone? Verizon's free cash flow could drop 50% from here, and they would still have enough cash to almost double the current payout.

And Verizon is not unique in this characteristic.

Another example would be Bristol-Myers Squibb (BMY). With a current market cap of $44.5 billion, BMY has kicked off $3.75 billion in free cash flow the previous 4 quarters. They could pay all of that cash out and give a solid 8.4% income at the moment. Currently, they pay out a healthy 4.9%, meaning that in the event of a 50% market crash, you would have to decide to sell them at yield of 9.8% and go to cash yielding .25%. Chances are in stressful economic times, the products they sell would be in higher demand. But even if their free cash flow dropped by 50%, they could still offer out a 4.2% yield in the worst of times. The risk to a BMY is eventual drug patent expiration, but the truth is, these types of companies have the franchises and cash flow to partner with most generics if not buy them out in order to maintain their cash flows.

In summary, if you want to mentally survive the next crash and not sell at the bottom, retrain yourself to think about income yields from individual stocks. Consider getting rid of mutual funds or story stocks who sell luxury products and don't pay out profits. Retrain your brain to think like a business owner and not a gambler. Litter your portfolio with companies like Verizon, Kraft Foods, and Bristol-Merys. Our portfolios have nearly 100 of these types of companies in them, so there are plenty to choose from. These moves alone will go a long way in helping you survive 30 years of retirement which should see many more bubbles and crashes if the Fed has any say.

Disclosure: Long KFT, VZ, BMY

About the Author: Timothy L. Ayles is the Chief Investment Officer of Napa Wealth Management, Inc. NWM has hand picked Tim both for his highly disciplined investment management techniques in building sensible client portfolios; and for his ground breaking developments in international mathematical investment models. Tim’s expertise is in the rarified atmosphere of commodity trading. He was the founder of Creative Investment Research Group that trained commodity traders all across the United States. Tim was born and raised in Napa and attended Biola University in Southern California.
He runs MA Capital, LP which is a long/short equity, private equity, and fixed income hedge fund. He is a Registered Investment ...More Advisor.