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The Correction: Protection Makes Sense

publication date: Oct 3, 2014
author/source: Brian Nelson, CFA

When our team thinks about members, the one thing we want for them is to make money from our service. This sometimes means that we’re a bit cautious at times. For example, taking profits on Ford (F), Precision Castparts (PCP), and Buffalo Wild Wings (BWLD) a couple days ago was not an easy thing to do. They’ve been huge winners. From a fundamental standpoint, we still like the companies, but market conditions and valuations cannot be ignored. Just like the profit-taking, we also think it was prudent to add protection in the form of put option contracts to the Best Ideas portfolio and Dividend Growth portfolio in light of a number of factors. The put option contracts amount to ~1.5% of the portfolios and may expire worthless.

One of the challenges we face is communicating these items so that they are easily understood. First of all, what is the definition of a correction? Does the market go down every single consecutive day during a correction? No. There will be days like Friday where a strong jobs report will drive the market higher and sometimes meaningfully. But despite the advance, we’ve only retraced a bit of the steep fall we’ve hedged for. We don’t want you to read too much into the graphic of the S&P 500 (SPY) above, but for perspective, the trend is still decidedly lower, even after Friday’s leap.

It’s important that members understand that the market does not converge immediately to a fair value estimate or target price in a straight line—there will be up’s and down’s along the way. The jobs report, released Friday, showed an unemployment rate that hit a 6-year low, reaching 5.9%. But by breaching the 6% level, in many cases, we’ve reached the definition of full employment, or according to the FOMC, somewhere between 5% and 6%, according to a Fed survey. The US economy is healthy, and the US equity markets—still near all-time highs—are already reflecting such optimism. But where will the next leg of growth come from? The US seems to be one of the few bright spots in a global economy that is under pressure from Europe and Russia to Africa and South America.

We hope that it makes sense why we’ve taken a conservative stance. Of course, we want our members to profit, and we also are targeting specific goals in the Best Ideas portfolio and Dividend Growth portfolio. Members must remember that the reversal on Thursday and the strong upward advance on Friday are encouraging, but we’re still in correction mode. Though this may seem counterintuitive to members that like to buy when markets are going down, we won’t grow more comfortable that we’re not in a defined correction until we break out to new highs again.

So what does this mean? Well, if you are a long-term investor with a time horizon of more than 5 years, it may not mean much. For us, our daily work isn’t changing much either, save for the recent string of daily commentary as we place greater attention on recent market activity. We’re still pouring through ideas and updating reports. In fact, we have a number of exciting high-yielders to add to the Dividend Growth portfolio in coming weeks. Kinder Morgan (KMI) is high-up on our watch list at the moment.

In the Best Ideas portfolio, we tend to be more opportunistic by letting the market tell us what we should own. Said differently, the third pillar of the Valuentum Buying Index requires firms to be advancing in price before consideration. Such a pillar provides much-needed market confirmation to the underlying valuation thesis of a company (i.e. covered extensively by the first two pillars). Catching a falling knife in a down market is always painful.

We’re monitoring the ongoing correction closely to see if things may get worse. Look for the daily market commentary to continue each day next week.

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