June's Panic Sell-Off Was a Practice Run: Here's What It Taught Us
When Fed Chairman Ben Bernanke suggested that at some point the Fed's $85-billion-per-month bond-buying economic rescue policy would taper, the market immediately panicked. A nearly month-long sell-off ensued.
The next statement from Bernanke attempted to calm those fears saying, in effect, "It's not happening soon." But for the average investor, this was merely a fire drill for what will happen once tapering begins.
What happened in June -- the panic -- will happen again, without question. And, just as is happening now, after that future panic, the market will recover and the prices will adjust.
That's a crucial insight you can use to your advantage. While seeing those downward-pointing red arrows on your portfolio screen makes you feel awful (and worse yet, poorer), knowing it's coming means you can prepare your portfolio for the stormy weather and suit up for some bargain-hunting.
The key news is that you now know the sell-off will be temporary. Here's what to do with that crucial insight.
Check the Winners
Hopefully, you have some stocks in your portfolio that have been great -- the ones you love to brag about at lunch with your friends. The scariest part about owning a winning stock is determining when to sell, if ever.
If a stock has had a rocketship trajectory for a few months or even a year, take a look at its valuation, evaluating its forward-looking P/E or enterprise value-to-EBITDA. Compare these metrics to the company's competitors. If your stock is trading sky-high, it might be time to take some profits. This way, when Bernanke gets on television to tell us the inevitable, you've secured your gains and can weather the storm. If you sell a couple of points below its height, don't beat yourself up.
Furthermore, if you really love the stock, and it plummets with the end of the Fed's bond-buying, you can get back in it at a lower price and ride the train back uphill. What could feel better than profiting from a great stock you know and love, twice?
With this profit-taking, your initial response may be, "What do I do with this cash?" Cash on the sidelines makes investors nervous, especially when stocks are going up and up. Luckily for you, there is a game plan for your recently freed-up capital.
On Wednesday, Bernanke told lawmakers that the bond-buying program will start to slow around year's end, and likely continue slowing until it reaches a halt in mid-2014. While he noted that this plan is not set in stone, it gives you a decent timetable to work with.
If you take some profits over the coming months, don't immediately reinvest your cash. Save it for when the fun begins -- i.e., Sell-off 2.0.
The likely drop in markets will inevitably create mispriced securities -- companies unfairly punished in the stock market and with undervalued prices. This is exactly what you want to happen, and this is when you grab the shopping cart.
The more volatile companies will be hit the hardest, and this may be where the greatest opportunity lies.
Companies that have shot up in value over the past year, for example, Tesla (TSLA), could get slammed with double-digit drops, whether deserved or not. If you believe in Elon Musk's quest for the long-range, high-performing electric car, you'll likely get an opportunity at freshly discounted shares come the new year.
When the panic begins, be patient. You don't have to start buying on day one -- let the fear build and the market drop. Once those stocks you've had your eye on appear battered and beaten, then back up the truck. Similar to selling at the peak, you may not end up buying at the absolute trough -- that's just fine. Timing is a generalized art and you can't obsess over minutiae.
An Optimistic Game Plan
While it may seem too easy for this plan to work, it's really not. For comfort, take a look at long-term charts of the various indexes. You'll see those big downward-sloping trends, where everyone ran around with their hands in the air screaming. But after every single one, without fail, there is a reversal. Those who bought in or around that panic point did very well.
Take a conservative, cautious approach in the months leading up to the Fed taper. Celebrate your recent victories, and lay off the buy button. Once the trouble hits, though, it's time to dig through the clearance bin.
Roll up your sleeves: If we're lucky, it'll be a full bin of bargains to choose from.
Motley Fool contributor Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Tesla Motors.