Special Feature: How I handled the market dive

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I’m interrupting my series on What not to buy to explain what I think was going on with the market during the dip in August and how I protected my investments during the uncertainty.

It was the week that threw so many people into turmoil. I’m not pretending I enjoyed it or found it easy; I certainly didn’t predict it. But I do like having to make calls. In my view, there was a lot more order than meets the eye. Here’s how my week unfolded:

Dear Diary,

Saturday 6 August: Wake at 8am to find that the US has lost its AAA rating. Don’t feel good at all, particularly as our market has already lost 7.2% this week. Spend the morning addressing risk issues in my margin loan – which is outside of my super fund, of course. Checking my plan takes me a few hours on top of the work I’ve already done in preparation for such events. I make a plan that would further insulate me from a margin call. I work out how much cash I have on hand and what I could sell if necessary – about 10 steps, and in order – depending on the severity of the situation. It’s a list that would allow for a massive fall in the market, just in case. I determine that if I do nothing, I could handle a 9% fall.

Read the news and realise that the US jobs data is quite good, but there have been more problems in Europe. Why is there no focus on the good jobs data? Slow growth, yes, but I don’t subscribe to US double-dip recession speculations.

Sunday 7 August: Rested. Don’t feel in the mood for our usual Sunday lunch out.

Monday 8 August: Wake to find that S&P has reaffirmed its short-term debt rating for the US of A-1+ (equivalent to AAA). Good news. Bloomberg explains that it’s this short-term rating that’s the key to money market operations. The previous downgrade of the US’s long-term debt rating is more symbolic than anything. So there are no short-term problems in the US, and Europe announces a plan; maybe things won’t get too bad, but I keep my plan of what to do at hand.

An easy morning. After an early fall, half of my stocks are up by lunch; but then the market slips 2.9% on the day. My plan is at the ready, but I take no action. Is the Bloomberg opinion on the money?

Tuesday 9 August: The US market falls more than 6% overnight. I give a teleconference to my clients explaining it’s just panic and not like 2007/8. Companies in the US and Australia are cashed up with really good earnings. Importantly, the relationship between our market and the US – when expressed in US dollars – leads me to argue that we have a 7% cushion due to the 7% fall in our dollar from near US$1.11 to US$1.03 in a few days.

Foreign investors needn’t mass evacuate our falling stock market because the stronger US dollar has protected them from losses. Conclusion: our market doesn’t have to fall as much as the in the US.

The market falls a couple of percent, so I transfer cash into my margin loan and sell some stock. I hold a little bit of the index in the form of an ETF (Exchange Traded Fund) – specifically STW – in my margin loan and my super fund for days like these. The index tends to fall slower than individual stocks on high fear days. I sell STW in my margin loan as well as some AGK as it, being defensive, also holds up a bit. Margin loan safe again. No damage done.

At this point I feel safe with my super, so I just sit tight. But I now have no spare cash in case the margin loan gets pressured again, so I sell my STW and a tiny bit of each of AGK and LYC from my super fund. This will give me cash in three days (upon ‘T+3’ settlement) to transfer as a tax-free pension to my personal account and then onto my margin loan. I have an overdraft facility to see me through the intervening period.

By lunch the market has fallen below 3,800, which is over 5% down on the day. The dollar slips below parity. I lie in the dark watching Law & Order Criminal Intent. Focus. I’m stressed, even though I’ve averted any significant damage. I assume the market is still falling.

At 1pm I go back to the computer to find the market experiencing a baby recovery. It screams up to close 1.2% higher on the day after being down over 5% – that’s a rally of about 7%. No obvious explanation from the wire services. Could it be the dollar story?

European markets open at 5pm (Sydney time) for their Tuesday. They’re not following our lead and go down heavily, but they too turnaround after an hour or two before my bedtime. The FTSE and DAX finish with a 7% rally from the intra-day low – just like us.

The US opens at 11:30pm in Sydney and looks bad when I wake at 3am to watch Bloomberg TV. US Federal Reserve chief Ben Bernanke speaks after Europe closes. The market falls further as he speaks and then does a 7% rally in the last hour.

So Australia, Europe and the US all have big downs then 7% rallies – unsynchronised.

Wednesday 10 August: Rumour is a big sovereign wealth fund was doing business yesterday, accounting for the large swings. There’s been a 5% rally in the US overnight. Our market’s up 2.6%, and 10% from yesterday’s low. Pressure lessened, but it’s not over ’til it’s over.

Thursday 11 August: Carnage on Wall Street again – down over 4%. I check my dollar story and find that we and the US are now dead level. Send out email to clients at 10am saying that there’s no need for our market to fall. It does fall, but then recovers to finish dead flat. More belief in the dollar story?

Friday 12 August: Big lead from Wall Street (+4.5%). Our futures market looks more modest. Decide to enact phase two of my plan. Lynas (ASX:LYC) is strongly up from its Tuesday low. I’m massively ‘overweight’ LYC from when they did the 1-for-1 capital raising in October. Back then, I had to sell some stocks (a reasonably balanced portfolio of BHP, COH, CSL, RIO, SHL, WBC and WPL [sold at a joint capital gain of 12%]) to pay for the parcel at 45 cents, which doubled my stock holding of LYC.

I didn’t want to sell the stocks but I couldn’t afford to bypass the 1-for-1 on LYC. The plan was to sell the superfluous 1-for-1’s at a good price over time and in an orderly fashion. Since LYC started climbing nicely, I started selling at about $1 late last year up to $2.57, and down again to $2.13. The ones I sold on Tuesday at $1.71 were a ‘no jealously’ risk sale. I sell today at $2.01 (average $1.95 for the week) but still have some of the 1-for-1’s left in my DIY.

My reason for selling LYC is that I’ve made a tidy profit and who knows what will happen next week. I plan to pay the proceeds of the transaction as a pension to myself in three days (which is the time stipulated under the T+3 rule) and whether I use the cash to bolster my margin loan or buy RIO outside my super will be determined when I get the cash on Wednesday after the close. If it seems we are back on track, I’ll sell the rest of the 1-for-1’s and get some more BHP before it retraces to above $40. If I do that, it will have taken 18-24 months to get that rebalancing right from the 1-for-1, but well worth it. Interestingly, the portfolio I sold in 2009 to pay for the 1-for-1 can be repurchased at a discount of about 10% on what I originally paid!

Saturday 13 August: Quiet night in the US (up 0.5%). Our futures (SPI) market is up 1%. And US retail sales are up 0.5%; Australia could do with some of that. Spend morning writing this column.

Lessons to be learned

I didn’t expect the intense volatility of this dip at the beginning of August. I, like everyone else I’ve heard from, assumed that the deficit ceiling in the US would have been handled responsibly. It wasn’t, and so S&P hurt the ego of everyone in the US who understands what a credit rating is. I question why S&P waited for the weekend to reaffirm the US’s short-term debt after downgrading the long term. It could’ve done both at the same time for less damage. Pay back?

My conspiracy theory, and my dollar story, made it easier for me to work through the week. I’ll never know whether I was right in my thinking, but if I hadn’t had a story, I would’ve sold a bit more.

I hope any interested readers understand why I have some stocks – like STW and AGK – ready to sell in a crisis. I knew that when I bought them. And the orderly way in which I’ve tried to handle my LYC over-weight position. Planning takes me a lot of time, and I stick to it.

My DIY ‘net position’ for the week was that I crystallised capital gains of 37% on stocks I’d bought over the last 18-24 month flat period, and I had no capital gains tax because my DIY is in pension mode. I made a capital loss in my margin loan of a little more than I made as profit in my DIY. That capital loss can be set against uncrystallised gains at some future point. So I was close to square for the week with no margin call. I can now take a further 21% fall in the market if I do nothing, or a 27% fall if I tip in my LYC proceeds on settlement. I also de-risked my overweight LYC position and I might even make money out of RIO going forward. The broker consensus target price would give me about 50% capital gain plus dividends over the next year, and my capital loss on STW and AGK will be set against that.

I don’t subscribe to this being a repeat of the Lehman Brothers collapse. And I know a lot about that as I was a technical expert witness in the Federal Court this March on some of what went on. This is not 2008 all over again. I hope the coming weeks will be quieter, but volatility clusters usually last a lot longer than this one has so far.

It’s always better rebalancing when the market is quiet. l try not to let the market catch me by surprise, but I never predict these things – nobody does on a consistent basis. I just know something bad will happen from time to time. I don’t know what it will be or when it will arrive, I’m just ready for the unknown. Next fortnight I hope to return to my What not to buy series. But if the market hits the fan in the next two weeks, I will update you on how I’m reading the market.

Woodhall Investment Research Pty Ltd
ABN 17 141 486 160

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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