Monday, May 30 , 2016, 1:57 pm | Overcast 63º

Craig Allen: What Does the Not-So-Stealth Correction in Some Stocks Indicate for the Future?

By Craig Allen, Noozhawk Business Columnist | @MPAMCraig |

The recent 7.25 percent fall in the Dow Jones Industrial Average, 6 percent drop in the Standard & Poor’s 500, and 6.5 percent slide in the Nasdaq Composite are being seen by many investors as “the” correction that many, including me, have been expecting.

Believing the worst is over, these investors have jumped back into stocks with both feet, rallying the Dow rebound by almost 800 points from the recent low, or by more than half of what was lost from the previous high to that low. While this bounce in stocks may confirm to many that the correction has come and gone, many others, after reviewing their portfolio performance, may find that the stocks they own have experienced far larger declines.

Many investment professionals these days preach Modern Portfolio Theory (MPT) — the theory of maximizing portfolio returns for a given level of assumed risk, or minimizing risk for a specific level of desired return. To put MPT into practice, many professionals use computer programs to identify the most efficient portfolio, meaning the one that will achieve the goals of MPT by diversifying the portfolio, using various asset classes in specific proportions, given the level of risk and expected return that is acceptable to the client.

While this theory sounds great, the practical application of MPT doesn’t always result in the desired performance for the client. Many professionals do not practice what they preach. Instead of using true diversification according to MPT, they elect to build portfolios that are less than fully diversified. Many investors, believing they have the knowledge and skills to invest their own money, fail to properly diversify — with potentially catastrophic results.

During the recent decline of the overall stock market, as stated above, the S&P 500 fell by about 6 percent. After the rebound that followed, the S&P 500 is now down by a trivial 0.5 percent from the all-time high. Investors might look at the current level of the market and assume that their portfolios should also reflect this performance. For many,  however, this is far from the case.

Portfolios often are constructed with concentrated positions in a few stocks. These portfolios will typically hold high-profile companies, such as Apple, Twitter, Facebook and other high-fliers that many professionals and investors believe are so good that the added risk of holding a concentrated position in these stocks is “worth the risk.” The problem with this less-than-diversified approach is that poor performance in even one position can cause significant losses to the overall portfolio.

When valuations are as expensive as they are today, any negative news from a company can send a stock price into a dive. Case in point: Twitter, which has been one of those high-profile, high-fliers, dropped 25 percent when it reported earnings recently.

Best Buy Co. fell 29 percent the day it reported disappointing earnings, and shares have fallen an incredible 42 percent since that report. Citigroup dropped 16 percent after earnings were reported, Goldman Sachs fell 11 percent, and CSX lost 10 percent. Even Procter & Gamble fell about 8 percent after its earnings disappointment.

Investors who hold these and other stocks with similar disappointments are experiencing sizable corrections within their portfolios, regardless of what the overall market may be doing. An investor holding a 10 percent concentrated position in Twitter would have lost 2.5 percent of his or her total portfolio value in a matter of days due to Twitter’s 25 percent decline. If this same investor owns several concentrated positions that have experienced similar large percentage drops, the investor’s portfolio could easily be down by 10 percent or more overall.

Unfortunately, many may hold far larger concentrations than 10 percent, as shown in our example. The larger the concentration, the more dramatic the impact of a sizable decline in that position.

From a big-picture perspective, the fact that companies like Twitter, which have achieved large gains leading up to their earnings disappointments and subsequent drops in stock value, are getting crushed when they announce negative news is a strong indication that stock valuations are very rich.

If this were not the case, a strong company like Twitter, which had one bad quarter but was otherwise executing its business model well, would not react with such a shocking fall in its share price. This reality underscores not only the risk for those investors who hold concentrated positions in stocks, but also the risk of a real correction — one of a much larger magnitude than the 6 percent the S&P 500 lost recently.

We often speak about stealth moves in the market, meaning that we can have a stealth rally or correction with certain stocks, industries or sectors while the overall market is doing nothing or is doing the opposite. Given the large number of companies experiencing major shocks when reporting negative earnings news, this stealth correction is not so stealthy.

Until valuations are brought back into more reasonable alignment with revenue and earnings growth, we will continue to be at risk for a more significant correction for the overall market. Further, we will continue to see stocks being punished mercilessly for any disappointments.

The recent decline in stocks was nothing more than a head fake, with the true correction still to come — a correction of at least 10 percent, and very likely 15 percent to 20 percent from the recent, all-time highs. Until we move through and past that true correction, the stock market will not be able to drive into a new growth phase.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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