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  5. What to do When the Market Plunges

What to do When the Market Plunges (first published August 2011)

Peter Hodson, CEO, 5i Research Inc.After the most volatile week ever, equity markets took a slight breather last week. The break now allows us to outline a potential ‘game-plan’ for investors for when volatility breaks out again (and we can assure you it will—likely sooner rather than later).

First, when confronted with daily 400-point market swings, the first thing you need to do is to stay calm. Of course you have heard this before, but when fear takes over, calmness takes flight. You can literally hear calm disappear from financial commentators, as they scream at you trying to tell you to either (a) sell everything, or (b) buy everything. You need to remember that, if you are actually invested in the market, then at the very least, you don’t need that capital today, when the market might be down 500 points. Take a day—week—month—to think about your investment strategy again. You can then execute that strategy in a rational market when markets more truly reflect what is happening in the economy, as opposed to swinging madly.

Next, put what is happening in the markets in their historical context. Aug. 8th’s 635-point drubbing of the Dow Jones Industrial Average, for example, was only the 35th-worst drop on record. Bad yes—but it doesn’t even make a top-20 list. We’ve all seen worse. Plus, while it looked bleak for a while, you need to remember balance sheet strength. Sure, most governments worldwide still have debt issues, but corporations themselves have much more balance sheet strength than they did in the 2008 crisis. Apple Inc. for example, actually has more cash than the U.S. Treasury right now. Corporate ability to withstand a recession is much better this time.

Continuing on, perhaps consider buying dividend-paying companies for your portfolio. You know that dividends represent the majority of an investor’s return over the long term, but another benefit of dividends is hidden but equally important: Dividends can prevent you from selling, period. When you know you have nice dividend cheque coming in every three months, you can at least get paid to ride out any market volatility. One strategy in rough times is to buy companies that just recently raised their dividends, on the assumption that these companies must be performing better in the existing environment. Two examples of these would be Russell Metals and Algonquin Power. Both yield about 5% after their recent dividend increases. Plus, both pay you almost twice what you might get from government bonds these days.

On a similar note, in a market panic you might be wise to avoid companies with any debt. Nobody knows exactly what is going to happen, but if you own debt-free companies at least you know your investments will have the financial strength to hang in there longer than a debt-laden company. In 2007and 2008, debt killed many companies. This time around, however, it is extremely easy to find debt-free companies, as so many hunkered down and raised cash after the last cycle. Again, like dividends, owning debt-free companies will also help you to avoid panicking yourself, when everyone else seems to be.

Finally, and this might seem counter-intuitive; consider buying small-cap companies. In times of market panic, small caps illiquidity clearly works against them. During that volatile second week of August, for example, some small companies saw their share prices collapse 15%, 20% and even 30% or more, sometimes falling more than three times what the market averages fell. But think about that for a second: if the economy is really rolling over, does a small company suffer three times as much as a large company? Probably not. In fact, a small company can likely adjusts its expenses faster than a big company, so may even be able to handle a downturn better. It will of course help if the small company is also debt-free. If you are a buyer, then, use that small-cap illiquidity to your advantage during market panics.

These rules should help you survive the next market plunge. There’s no guarantee, of course, other than that—some day—you’re going to get another one.

Peter Hodson, CEO

5i Research Inc.