If you have been following the market on a daily basis this year you may feel like you are on a bad roller coaster ride that won't ever end. To make matters worse, it seems the overall global economy is struggling to stay healthy. How can you pick a stock in this environment? Is it better to just keep your money in cash or is a down market a good time to buy stocks at a lower cost? Let's take a look at the head winds the market is facing, some stock market basics you should always keep in mind and what to look for when buying stocks.
Things to Remember
Markets go up and down. They always have and always will. While it may be stressful to see your portfolio go down, keep in mind that from Jan. 2, 2009 to Dec. 31, 2015 the market went up 128.01%. Since it's difficult to predict which way the market will go, market timing may not be a good idea. Instead you could allocate some of your portfolio to index funds. With index funds you could take advantage of dollar-cost averaging instead of keeping cash on the sidelines. (For more, see: Dollar-Cost Averaging Pays.)
With that said, one of the keys to growing a portfolio is minimizing your losses. It is harder to get back to even after a loss. Market timing with cash and strategic stock purchases can be vital to keeping your losses as low as possible. This brings us to what to watch for in this market so you can try and minimize your losses while still putting yourself in a position to take advantage of the next stock market growth phase.
Continued Volatility
The volatility that we have been experiencing will be here for a while. There are a few reasons for this. First, the news coming out is mixed with good and bad information. Just when one stock announces great earnings, another announces terrible earnings. Add to this bad news coming from China and the oil industry and good news from jobs and housing. Enter volatility. (For more, see: The 3 Best Low Volatility Strategies for 2016.)
Second, even though the Federal Reserve raised rates for the first time since 2006 it was not enough to satisfy yield seekers. Those needing more income from their portfolios will continue to turn to stocks with higher dividends than what they could get by being invested in bonds. This chase for yield will continue to push many solid company stock prices higher. So while the market overall may be going down, you still might not find reasonable prices on quality companies.
Third, many investors still remember how bad it was in 2008 and 2009. Most are driven by emotions, causing many investors to move out of stocks when the bad news hits because they don't want to endure the large losses they previously experienced. This is especially true if the investor is close to retirement. Investors need for yield plus their emotions will continue to drive the market up and down until growth becomes more stable again. (For more, see: How to Avoid Emotional Investing.)
Corporate Profitability
When companies cannot continue to grow earnings through organic growth they turn to other ways to increase their earnings or at least to make it look like they are. First they start to lower their expenses through internal cost cutting. After that they begin to turn to mergers and acquisitions as a way to bring more revenues to the company. Finally they begin to implement some financial engineering by doing things such as share buybacks.
Last year was the biggest year for mergers and acquisitions since 2007. It was also the year of the buy back, as companies continued to buy their own shares. According to FactSheet, in the third quarter of 2015 companies bought $156 billion of their own stock. With companies resorting to these measures to increase earnings you need to be extra careful in analyzing a stock. Making sure they really are a solid company will take more research in the current market. (For more, see: Stock Buybacks: Breakdown.)
Cash or Stocks?
As you continue to add to your cash position should you leave it in cash because of the above factors or can you buy any solid stocks? Following are questions to ask before buying. Use them as a guideline before moving out of cash.
Are profits stable or growing? Many may consider gas companies a great buy right now because they have fallen so far. However, the market is not stabilizing anytime soon. On the other hand if a company is just down because the market is down but they are still growing and nothing fundamental is changing then it may be time to move some of the money from cash to stock.
Are dividends stable? Dividends are a large portion of the total return you get on a stock. If a company has a dividend that is stable and they have a low dividend payout ratio, then you might consider buying it. If the price of the stock is not going to go up, at least you get the return from the dividend.
Am I okay owning this stock for at least five years if the stock market continues to tank? In other words, do you believe in the business enough to know that management can get through a downturn and come out on the other side healthy?
If a stock does not satisfy at least two of the three things above, leave your money in cash and look for companies that meet these requirements.
The Bottom Line
While the market is struggling, sitting in all cash means you may miss out on some good buys. Take the time to understand a company and why it is reacting to the market the way it is, then buy when it hits the target price you want.
