Three Questions To Ask When The Market Freaks Out

By Chad Henage - June 7, 2012 | Tickers: AFL, AAPL, FOSL, INTC, MCD | 0 Comments

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Whenever the market decides to take a jump off a cliff like it has in the last month or so, I try to talk myself through it by asking 3 questions. Remembering to be calm and rational is difficult during times when the market drops, but it's necessary for every investor to do this 5 minute gut check.

Is It The Market Or Is It You?

Is your stock picking method flawed, or is the whole market selling off? The reason I distinguish between the two is, I've caught myself sometimes making a comment like, “I can't believe that Fossil (NASDAQ: FOSL) sold off by that much after earnings. The market has really been horrible recently.” However, I'm talking about a company specific event and not something that applies to the whole market. During market drops, you need to look at each company you own and ask yourself if you would buy the shares again. Hopefully you still like the company and the drop in price creates an opportunity. Other times, you'll realize that you were wrong about the company and the market drop shakes you from your complacency. Peter Lynch once said, “there is nothing wrong with losing money on a stock. However, what is a great tragedy is continuing to lose money, or buying more, while the fundamentals are deteriorating.” Just to be clear, when it comes to Fossil, it seems this is a short term issue that the market has overreacted to. This is a company that is slated to miss estimates for the whole year by 3-5% and it caused an over 50% drop in the stock. I look at that as a buying opportunity. Once you've decided whether this is a stock specific event or the whole market is selling off, the next question is can you do anything about it?

Do You Have Dry Powder?

If the market sells off, there are generally two types of investors. The first type is the 100% fully invested all the time type. This person has to look at a market sell-off as a test and nothing more. Since the person is fully invested, if they see a bargain they would have to sell something to buy something else. The second type of investor is the one that benefits the most from these drops. That is the person who consistently keeps a certain amount of money on the sidelines. I'm not talking about timing the market. What I am referring to is, the investor who keeps some “dry powder” (cash) on the sidelines specifically earmarked for these types of opportunities. If you are such an investor you have to be willing to do two things. First, you have to be willing to wait and do nothing with this cash until the time is right. Second, you have to know that a market correction, and a slight drop in a stock are not the same thing. I would define a correction in a stock by a drop of at least 10% from its 52 week high. Assuming you feel the stock is fairly valued to start with, a 10% drop usually creates the type of opportunity you would want to take advantage of.

Are There Potential Bargains?

If you are one of these investors who has some cash on the sidelines, a market drop is the time to look for bargains. One of the better examples I could give is Aflac (NYSE: AFL). This company is a successful dividend and earnings machine that just doesn't get enough respect. You can buy Aflac for just 5.88 times 2012 full year estimates. For a company with an 11% expected growth rate, and a 3.4% dividend that sounds pretty good to me. The stock is going through one of its typical downturns as people fret that the company's investment portfolio will suffer from the uncertainty in Europe. With the 52 week high at $50.33 and the stock currently at $38.38, you are getting it at a 23.74% discount to its 52 week high. Other companies that look like decent values right now are:

I know that some people might argue these choices, but the reality is none of these companies is significantly different than it was a month ago. Just to prove the point, how many people wish they bought McDonald's in the market crash of 2009 at about $54 a share? An even better example is what about buying McDonald's in 1987 when Black Monday occurred? Look at a long-term chart of McDonald's and you would have a hard time finding Black Monday when the stock was at a split-adjusted $5.50 a share. Market corrections can create opportunities to get a great deal on solid companies.

Conclusion:

The point is market corrections happen. Their severity and timing is almost always unpredictable and you have to accept that to be invested. You have to keep your long-term focus and realize that this too shall pass. I love the comment that Peter Lynch once made about market corrections. He said that, “market corrections are as routine as snow in Minnesota. When it snows in Minnesota, people don't assume it's the beginning of the next ice age, they just shovel out, pour some salt on the walk and remember that spring is coming.” In the same way, a market correction doesn't last forever. For a stock picker with cash to invest, a correction might be a great opportunity.

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