Two days up, two days down (one big one) and what appears to be an up day to close the week: That’s for all practical purposes a wash for the S&P 500, the widely watched blue chip benchmark index for the US market.
You wouldn’t know that from scanning headlines, most of which would leave the impression we’re in the middle of a real 2008-style meltdown. But the broad stock market has pretty much also been a wash for 2012 so far. In fact, since the great technology bull market peaked in late 1999, overall stock market returns have been pretty close to zero.
That’s bad enough news for those trying to build wealth over the past decade. But there have also been plenty of opportunities to lose big, as volatility has reigned supreme. First came the devastating bear market of 2000-02, which took the Nasdaq down more than 80 percent, nearly halved the S&P 500, and even caused the Dow Jones Utility Index to drop almost 60 percent.
The five-year recovery period that followed saw the S&P reclaim its old highs and the Utility Index blast to new highs, more than a third above the 2000 peak. The Nasdaq, however, gained back less than half its lost ground before the 2008 crash erased the recovery’s hard-won returns.
The past three years have been good ones overall. But only the Nasdaq is on higher ground than it was before the crash. And as the activity this week demonstrated once again, volatility is jagged as ever.
Not the Enemy
Based on conversations with subscribers, it’s the volatility that seems to aggravate them the most. And unfortunately, I can’t say when stocks will get back to a period of greater stability.
Memories of the 2008 meltdown are still very fresh in investors’ minds. And there’s no shortage of potential catalysts to set off selling. Volatility is also greater now than in the past because large institutions dominate trading as never before. And because fund managers’ performance is constantly being assessed, they simply can’t afford to be patient with a losing position too long.
Fortunately, volatility doesn’t have to be your enemy. Indeed, there are some very easy ways to make it your friend, and in fact a valuable tool for building wealth.
The simplest is to automatically reinvest dividends, preferably through low-cost dividend reinvestment plans (DRIP). Your dividends always buy more shares when the stock’s price is low and fewer when it’s high. The longer you stick with a dividend-reinvestment plan, the more money will be reinvested every quarter. And if you hold long enough and the company regularly raises dividends, the amount you’re reinvesting each year will eventually “lap” your initial investment.
I’ve been employing this strategy myself for the past 20 years with Utility Forecaster recommendations. As dominant providers of essential services, utilities are ideal companies for DRIPs for two reasons. First, they’re constantly investing in recession-resistant industries, producing rising cash flows and increasing dividends.
Second, utilities always recover from disasters, both self-inflicted and otherwise. All they have to do is repair relations with regulators, cut debt and eliminate the operating risk that got them into trouble. Even if your DRIP’s value gets smashed, you can count on a recovery. In fact, the longer the company’s share price stays down, the more shares your reinvested dividends will buy, and the fatter your ultimate payoff will be.
No other industry can boast this quality. And I strongly advise dividend re-investors make sure their companies have similar qualities. The DRIP Investing Center on the Utility Forecaster website has more information for investing in DRIPs.
A more aggressive way to take advantage of volatility is to use buy-limit orders to time purchases of stocks you want to own. A buy-limit order is executed only when the price you set is reached. For example, say you set a buy-limit order for energy midstream master limited partnership Enterprise Products Partners (NYSE: EPD) at $45 per unit. If Enterprise falls to $45, you’ll own it.
The trick in using buy-limit orders is setting a price high enough to get executed, but low enough to lock in the price you want. It will almost certainly take a real market calamity to knock Enterprise down from its current level of around $48 per unit to $30 a unit. But if you were able to buy at that latter price, you’d be locking in an extremely safe yield of more than 8 percent with growth of better than 5 percent a year.
One possibility is to set buy-limit orders for stocks you want to own at or near the lows hit in 2011. In Enterprise’s case, that was actually below $30. On March 15 last year, the unit price opened above $40. It also closed at roughly that level, but not before plunging intra-day to $27.85, as numerous stop-loss orders were executed and temporarily unbalanced the market. The drop was quite short-lived but very real, both for those who were stopped out at an abysmal price and for those who had buy-limit orders in place and have since enjoyed monster gains.
The one danger of using buy-limit orders is if the underlying company really does come apart, and the price drop is related to a real loss of wealth-building potential. That’s why you should monitor any company for which you have a buy-limit order in place, just as you would if you already owned it. And it’s another good reason to stick with only the most solid companies for this strategy.
A third way to take advantage of volatility is to periodically take profits on stocks that have exceeded their ability to build wealth for new buyers. Since late April, investors have sold stocks they perceive as risky, but also bid “safe” stocks higher. These moves have been further amplified by the fact that many investors now equate rising stock prices with safety and falling prices with risk.
At last count, more than half of the Utility Forecaster Portfolio stocks traded above my recommended buy prices. Most aren’t expensive enough to sell outright. But you can never go wrong taking a little money off the table from time to time, as I recommended doing with Enterprise earlier this year when the unit price was pushing toward the mid-50s. Those who heeded my advice booked a gain and now have funds to reinvest at a lower price.
The extent to which you pursue this strategy will likely depend on how actively you want to trade. But the more you pay attention to value and the less to momentum, the more you’ll be able to take advantage of volatility using all three of these strategies. That means you’ll be systematically buying low and selling high, which is the key to building real wealth in stocks.
What to Avoid
I also strongly advise against the use of stop-losses, particularly trailing stop-losses. Like buy-limit orders, stops are only executed if a particular price is reached on the downside. The difference is the selling price is whatever the market will bear after that. And if enough stops are executed at the same time, the actual selling price can be quite a bit lower. Just ask those who were stopped out of Enterprise on March 15, 2011!
The way to protect yourself from heavy losses in individual stocks is to sufficiently diversify so one or two losing positions won’t sink your entire portfolio. Then keep a careful eye on the underlying businesses of the stocks you own.
As we saw in 2008, dividend-paying stocks that hold together as businesses and keep paying dividends always recover from stock market losses. Recovery from the selloffs of 2010 and 2011 were even faster.
You can’t completely avoid volatility when you buy stocks. And it’s almost certain some of your stocks will lose ground if market conditions worsen this summer.
That means if the underlying business of one of your companies does start to weaken, you’ll need to be prepared to take a loss and move on to something else. If you’ve chosen wisely, however, that will apply to only a very small number of your holdings. The rest will recover and move on to higher highs as market sentiment becomes positive again.
Remember, value is the key to wealth building. Volatility often has nothing to do with value, but it can help you buy value cheaply, as well as take a profit when it no longer exists.
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