Over the weekend, all the talking heads and media types were talking about how bad the market has been this year. To hear the discussions, you would think we had experienced a major crash in recent weeks. I do not want to whitewash it in any measure, but the truth is that, so far, the market has not been so terrible. For the past 52 weeks, the stock market has returned about 8%. Year to date, it is down just about 5.5% and roughly 17% below the highs for the year. That's not wonderful, but it's not crash territory just yet either. A really bad market has peak-to-trough drawdowns of greater than 40% such as we saw form 2000 to 2003 and 2007 to 2009. That's a bad market. There is still a good chance that we will see a really bad market develop as the economy struggles and Europe implodes, but we are not there yet.
I am not seeing the type of one-year plunge in prices that would constitute a really bad bear market yet either. Several years ago, Charles Brandes released a study about catching stocks that had fallen 60% or more in value. The study by the Brandes Institute found that these stocks outperformed the market by a substantial amount for the three years or so after the decline. When you look inside the numbers a bit, it appears that on average there were about 95 stocks per year on average that had market caps larger than $100 million and had fallen by at least 60%. Right now, there are 96 stocks that fit the definition of a fallen knife, so it is not exactly at the extreme levels that would indicate a bear market bottom.
My point here is that the market has not been a lot of fun the past few weeks but it has not catastrophically sold off either. I hear pundits telling investors to get aggressive as stocks decline and buy stocks in the decline. I think that getting aggressive right now would be a huge mistake. There are some cheap stocks and I have been buying them as readers are aware. European financials are very cheap and I have initiated positions in Royal Bank of Scotland (RBS) and Aegon (AEG). However, I did not push all in, buy a full position or use margin. I am scale buying everything right now and I am well aware that these stocks could go a lot lower before they go higher.
I have used the same logic with the U.S. banks I have been buying. I have opened small positions in most of them and structured combination trades on others. I like the combination trade on banks such as KeyCorp (KEY) and Fifth Third Bancorp (FITB) at current levels. The premiums help finance the investment and force me to buy lower if the prices continue to fall. Banks are cheap, but given current economic and market conditions, I have to keep in mind that they can still fall a lot lower. Scaling in and using options to create positions at lower prices strikes me as the right way to invest right now.
I would love to call for a major bottom and suggest backing up the truck, but I just do not think it is time yet. The market has not fallen far enough and there not enough destroyed stocks to suggest abandoning a stay-small, move-slow approach to buying stocks. The secret to success as a long-term investor is surviving the long haul. Caution and discipline can be the best tools we have available.