How do you catch a falling knife?

August 8, 2011

I pondered this question as I drove back from work some hours ago. After months of difficulty finding bargain stocks, the incredible one day 7% drop in the stock market over the past 12 hours, combined with the decimation that occurred over the last week, has finally brought many stocks into value territory. But as soon as one difficulty was solved, another arose. How can I take advantage of a possibly fleeting drop in prices, with so many possible stocks and so little time? I have a modest database of several hundred stocks that I have previously investigated in detail, but if I am to place my orders the next trading day, there is not enough time to carefully peruse the latest stock-specific news. Clearly, some kind of quick-and-dirty statistical measure of value will have to be substituted for the usual carefully poring through the annual reports. Through a selection of 20-30 stocks based on some crude measure of value (I’m leaning towards free cash flow multiple), I can hedge against the few bad calls that will probably occur. I intend to place an additional 20% of my portfolio to this strategy, using margin to do so.

I discussed my plans over dinner with the wife, and was asked the inevitable question: What if the stock market falls further? I answer that since we cover all living expenses from my salary and have no need to draw on our investments, and that we are only moderately leveraged through margin, it is highly unlikely that we will meet a cash crunch or a margin call and be forced to liquidate. But in the back of my mind, I am debating the question, is the stock market really the best asset class now? What asset class will best be able to withstand even a double dip recession? Gold is clearly the asset du jour, but I am uncomfortable with an asset with no intrinsic value and negative carry costs, necessitating careful daily tracking of the price to ensure that I do not miss the popping of the bubble. Timberland, farmland and real estate are attractive, and I intend to try and include some REITs in my portfolio. Holding cash or bonds with their extremely low yields is unattractive to me, given that interest rates are at record lows, and not sufficient to compensate for possible default. I would rather hold blue-chip dividend paying companies that can clearly survive a recession.

As I write this, I am racing the clock to complete my portfolio selection before the market opens. I’ll be leaning towards dividend paying stocks, but since minimal analysis would have been done, I’ll probably treat it as a basket of stocks, and report the overall gain/loss based on the entire basket on this blog some time in the future. But for now, I need to buckle down and do some stock selection.

P.S. The Obama administration is clearly clueless about what is driving the markets. The S&P downgrade itself is a non-event, as evidenced by the flooding of funds into Treasuries. It is the reaction to the downgrade, with the possibility of extreme fiscal austerity tanking the economy, that has the market spooked.


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