Navigating The Correction | Seeking Alpha

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(Note: This article was originally published in the marketplace newsletter on January 30, 2022. It has been updated as needed.)

There is a myth that has made the rounds for as long as I have been an investor that the market rallies and corrects. The truth of the matter is that industries have their own cycles. When enough of those industries rally, then the big averages like the Dow will show a bull market. The same goes for corrections. But that does not detract from the fact that there is always something correcting. Similarly, there is always a sector going up.

Now some readers are great with charts and can float from industry to industry with considerable success by relying upon those charts. Many more investors are familiar with one or two industries. Then they either rely upon mutual funds for the rest or a respected expert. No matter how you do it, from time to time an industry you follow becomes so weak, that a correction or worse is inevitable.

In the case of tech, the industry was beginning to correct back in 2016. That in and of itself would have brought an end to a remarkable bull run. I should also mention as an aside that there will likely be more of those remarkable bull runs in the future as technology continues its march onwards.

But the increasing deficits combined with the tax cut made for too much money chasing too few goods. As we discovered in 2008, (which was another case of increasing deficits after the previous administration had balanced the general fund), such a situation causes problems. Had we resolved the many lending issues in 2008, there was still too much money chasing too few goods. Both the stock market and the real estate market suffered.

This time around that money headed into the stock market (also to the real estate market again) and more so to tech. That provided for a momentum-based casino atmosphere along with sky high valuations. This of course is also an asset bubble.

Now the politics appear to have swung to conservatism with the previous big spenders of the last four years or so claiming to have “found religion”. If that happens to stick, then there is no way that the overpriced crowd is going to be bailed out with more easy money fiscal and Federal Reserve policies. Then from an economics viewpoint, the overpriced things everywhere are going to have a day of reckoning.

This happened with oil and gas after the 2018 rally. I personally don’t like to short oil and gas because of the political interference that leads to very low visibility. Things can literally change overnight. However, the OPEC pricing war followed by the coronavirus demand destruction provided an ideal time to either buy puts or short stocks. The problem is that was hindsight.

Now along comes tech with a far more overvalued bunch of companies. Future visibility appears to be much better than is the case with oil and gas. My own way of handling corrections is to go to the most overpriced industry of the bunch and buy puts. I generally limit my exposure by buying out of the money puts because I expect a price implosion by the worst of the bunch. I further will seek to purchase puts that are 6 to 12 months in duration so that there is time for this to work. Some investors would use leaps in this situation. That should work as well.

I don’t usually pay attention to the broad indexes as they allow for maybe a 10% to 20% correction. There are some inverse EFT’s and mutual funds that can be used for the purpose, and they are leveraged while also being professionally managed.

My own way comes from business school where we learned an income strategy was to put 95% of your money in safe government money market funds and the other 5% in a well-chosen basket of options. This was considered low risk with the caveat on the “well chosen” part of the options. Of course, researchers had access to history, and I personally believe the results were tilted somewhat by the access to history. Nevertheless, it does point out a way to ride out the current storm that is available to income investors and some who can stand more risk.

For myself I first chose Netflix (NFLX). The reason is that I had been covering the virtuous cycle that management explained to investors when they first went public. That management thesis was “out of order” for quite some time because it appears that the costs for content are now and have been considerably above what management envisioned when they went public. Meanwhile, over the very long term, revenues have really not kept pace. The result is the cash flow statement rarely shows any cash flow from operating activities throughout the company history in any fiscal year.

Management kept putting off the inevitable by either selling stock or taking on debt. The interesting part about this was that in management’s eyes, the debt was such a small part of the company market value that it was not an issue. Left unstated was that consistently negative cash flows from operating activities left no money to repay the debt. The exception was 2020 when the company shut down the new content due to the coronavirus. Even then cash flow was not going to cover the cost of the assets on the book for content.

However, growing companies can show negative cash flow and this company hid behind that even though management had many times proposed a year for the cash to come rushing in. What was so important this year was the surprising first quarter new subscriptions guidance. Often slower growth provides an end to crazy valuations.

A return to normal valuations has clearly begun. The real question is what to compare it to? Probably cable companies and other TV stations. But those values ​​are nothing close to the current stock price.

So, what I do with the Netflix’s of the tech industry is generally buy a put that is 6 months to a year (or maybe even 2 years) out. I often limit my exposure by buying one out of the money. If you are expecting a major re-evaluation like I am, then an out of the money one will do the job.

If and when that put doubles in value, I then sell the put and replace it with another out-of-the-money put to keep my exposure down. This has the advantage of “taking money off the table” while not allowing the puts to “take over the portfolio” as that would provide unacceptable volatility and risk.

IN the case of NFLX, I bought a $410 one when the stock was $585 (give or take), and it went until September. I sold it when it doubled. I repeated the process again and am now on my third Netflix put. The stock price is now about $175 and the latest $215 put has a 72% gain (it expires in September). Not every one will work out like this. But like stocks you only need a percentage to work out to win.

Admittedly, I could have bought and held the first put for months. But I always have an objective of controlling my exposure. Should the market turn, and I lose my entire investment, I have the profits I took to overcome that total loss.

Summary

Generally I look for the most overpriced industry I can find and then the worst possible charts. NFLX was an attraction because the stock price was heading straight down at the time. So it did not take a whole lot of chart knowledge to realize the price was heading towards a new world with different future valuations. Tech has a lot of these and some of you will be more familiar with names I never got to. Since I started this, I have expanded my put position and now have several. The key here is to find the most overpriced industry with the worst charts you can imagine.

Again, I don’t like a lot of corrections strategies because they don’t give you the best opportunities to make decent money. Here, I am going for at least a 70% price collapse and usually 90%. Price changes can be different from the health of the business. The key here is that most of these companies are priced to perfection (and more) with unrealistic market expectations. They were able to maintain those prices due to the Federal Reserve policies of easy money and the fiscal policies that added considerable debt. From economics, this led to a stimulation of an economy that was already in good shape. In Economics 101 in any college, the cost of such a policy has not varied in decades. Unfortunately, now with two of these under our belt, we as a country need to learn what economists have been teaching for a long time (a good reference would be the Samuelson textbook).

This also runs into another (in this case management) theory that has been well documented. Typically, the big boys of the industry allow a newcomer to “create” a niche that is at least $1 billion before they even consider entering. If that is the case, then the entrance of Disney (DIS), Apple (AAPL), and Amazon (AMZN) into streaming should be no surprise. DISC is on its way after the AT&T (T) deal. The books on this would include “Competitive Strategies” by Michael Porter.

Most research shows that the newcomer either does not survive this onslaught or does so as a very different company. Those of us who are up there in age like me may remember that AAPL had 100% of the personal computer market. Then IBM (IBM) entered and took 33% virtually overnight. A few years later and AAPL was in some dire straits with maybe 5% of the market it once commanded. That’s pretty typical. Another one is AOL. That one has been largely replaced by Google (GOOG) (GOOGL). Hopefully, that gives you some idea. But generally the key to the correction is the beginning of slower or no growth.

I hope this long winded explanation helps somewhat. But with some fairly straightforward analysis, you can line up things in your favor on something like this. The key is when it looks like it is ending (meaning the stock ignores bad news and begins to react to good news as it should), you have to walk away and not look back. Notice that Netflix made a real small bump up when Ackman got the $1 billion position in the fund he managed and then right away made a nominal downturn the next day. It will take more than one hedge fund to stop what is going on here.

Again, there are a lot of Netflixs out there. Another indication is how the top few are 25% of the S&P 500 index. That alone usually signals it is time for a valuation adjustment. Big key is to limit your exposure to no more than 5% total. Also remember that these adjustments happen relatively fast in this age. The day of month after month stock declines for 18 months is clearly over. That was the 1970s. This one is expected to last 2 to maybe 4 months. Hence the long dated put recommendations.

If you keep your eyes open, there is nearly always a situation where some stock disappoints and it’s because the big boys entered. That normally will over time send a stock spiraling downward. But you have to be patient enough to look for the pace of growth slowing. Otherwise these overpriced ones remain overpriced.

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