Falling stock markets can be good news for canny investors. But the key is to stick to solid blue chips in core industries,writes Harvey Jones
Every investor loves a rising stock market. Remember the fun we had in the great bull run of the late 1990s? Or the dotcom boom? Or in the years before the banking crisis?
There's nothing like seeing markets rise 10 per cent or more year after year to start the investment party swinging. Even people who would never consider buying stocks can't resist gatecrashing the fun. The lure of a rising stock market is hard to resist, and who wouldn't want to celebrate that?
But maybe we have got it the wrong way round. The problem with a big fat stock market party is that it invariably ends with an ugly hangover. When the dotcom bubble burst in 2000, for instance, it obliterated US$5 trillion (Dh18.3tn) of stock market value in two years. And just look at the communal headache we are suffering today.
We should be very suspicious of a stock market boom, especially as it gathers momentum and all the latecomers start banging on the door, demanding to be let in.
Instead of celebrating success, perhaps investors should be celebrating failure instead. It sounds counter-intuitive, or even downright odd, but there are good reasons why investors should be happy when it rains.
Stock market investors are a strange bunch, says David Kuo, from The Motley Fool, an investing website. "We celebrate rising share prices, even though it means we have to pay more for the shares we want to own. We don't cheer when the price of petrol goes up, for example. Or if food prices rise. So why should we celebrate when share prices rise?"
If you're a short-term trader, a rise in share prices allows you to make a quick profit. Fair enough. But it is a different story for long-term investors, Mr Kuo says. "Private investors should celebrate falling markets because it means they can pick up long-term winners at bargain-basement prices."
By that logic, now is a great time to buy shares. The Motley Fool has spent this turbulent summer urging its users to snap up solid global blue-chip companies. At today's discounted prices Apple, BMW, Diageo, the drinks giant, pharmaceutical companies such as GlaxoSmithKline and Roche Holdings, Google, Tesco, the UK supermarket chain, and Unilever, the household goods company, have all been high on its shopping list.
When the market valuation of a stock falls below what you think is a fair price, treat this as a great buying opportunity, Mr Kuo says. "When markets are volatile, the opportunities tend to come thick and fast. So rather than be afraid of volatility, or run away from it, we should learn to embrace it."
Mr Kuo names British American Tobacco (BAT), the global cigarette giant, as a good recent example. "It was unwanted and unloved at the start of 2011 - it was almost as if the market expected everyone to give up smoking overnight. Yet there was never any suggestion that BAT's profits would stop rolling in or it would stop paying dividends."
BAT's share price rose a smoking 20 per cent in 2011. "If you include the dividend, the total return was an attractive 26 per cent. Opportunities like these will come around in 2012 as well because markets are likely to remain volatile," Mr Kuo says.
If you believe bad markets are good news for investors, you might enjoy the coming year, says Adrian Lowcock, a senior investment adviser at Bestinvest, the London-based independent financial advisory. "Right now, 2012 doesn't look like it will be much better than 2011, although it could surprise us," he says. "Either way, if you're investing for the long-term, weak markets provide better opportunities than overvalued ones."
The key phrase is, of course, "long-term". Falling stock markets are nothing to celebrate if you need to cash in your investment pot in the next year or two because you are going to retire shortly or want to buy a property. If you're investing for at least five years, but preferably 10 years or longer, they are a great opportunity to meet the first condition of the ideal investment, which is to buy low.
The second part is to sell high. You can worry about that later.
There are plenty of reasons why markets should continue to struggle this year, says Gaurav Kashyap, the head of the DGCX desk at Alpari ME DMCC, the Dubai-based online trading brokerage.
"The European sovereign debt crisis will keep risk appetite in check, especially since markets haven't seen any viable solutions. The Band-Aid solution to the US debt ceiling is likely to come undone early in 2012 and the ongoing political gridlock in Washington will weigh heavily on US markets, especially in a presidential election year."
Emerging markets have enjoyed years of runaway growth, but they are now starting to slow. "Higher commodity prices and falling manufacturing output should hit markets in China and India, particularly in the first half of the year, and we haven't yet seen the full depth of the downside."
If you have successfully trained yourself to celebrate falling markets, Mr Kashyap's gloomy forecast should have you putting your plans on ice. At some point, there could be a great time to buy. "The Dow Jones currently trades at over 12,100. If it fell to, say, 10,000, that would be a great opportunity. The S&P 500 is currently around 1,250. If it dipped towards 1,000, again, this could be a good entry point. Stick to companies in core industries with strong balance sheets," he says.
Although it is tempting to hang on for the perfect buying opportunity, this strategy can backfire. The first danger is that the crunch never comes. Markets muddle along for a while, then surprise everybody by starting to rise - and you have missed your cheap and cheerful entry point.
The second danger is that the crunch does come - and you miss it. When markets are in disarray, it takes grit and nerve to coolly go shopping for cut-price companies. Most people don't pluck up the courage until the market has already rebounded.
Maybe you're made of sterner stuff. If you think you are, ask yourself this question: what were you doing at the start of March 2009, when global stock markets hit rock bottom? Were you on a shopping spree for cheap stocks? Or were you sitting on the sidelines like everybody else, still frazzled from the crash of the autumn of 2008?
Timing stock markets is almost impossible, says Clem Chambers, the founder of Advfn.com, the stocks and shares website. "That's what I aim to do and I wouldn't say I'm particularly good at it."
There are certainly plenty of cheap stocks out there right now. "The danger is, they may get cheaper," Mr Chambers says. "In fact, they might get a lot cheaper. Just look at banking stocks. They looked cheap a year or so ago, but now they're a lot, lot cheaper. You can celebrate falling share prices, but you're unlikely to catch the bottom of the market."
If you want to stock up on cheap shares, do your research carefully. "You have to know what you are buying. Don't buy a company because somebody has told you to; do your own due diligence. You are investing real money, so be careful with it. Only buy stuff that is absolutely too good not to buy."
Then you have to be patient. "Investing is a case of win some, lose some. Save your money and slowly acquire stocks and over five or 10 years, you should come out nicely ahead," Mr Chambers says.
You should also consider setting up a regular savings plan to drip feed money into the stock market every month rather than taking a punt with a big lump sum.
Regular monthly investors should definitely celebrate falling stock markets because it helps them to benefit from a process called pound-cost averaging. If share prices fall, you benefit by getting more stock for the same monthly payment, provided markets rise before you cash in your investments.
For most investors, celebrating falling markets is a step too far. It may make shares cheaper to buy, but it erodes the value of the shares we already own. And that hurts.
But in these turbulent times, it pays to remember that falling stock markets may also be a great opportunity, says Mark Dampier, the head of research at Hargreaves Lansdown, the UK's largest independent financial advisory. "The best time to invest is when everybody else is running around in panic. That's when the real bargains can be found."
If we do learn to love falling stock markets, then shouldn't we also learn to hate rising markets? We should certainly be suspicious about them. There is always the danger of getting caught up in the euphoria and throwing good money after bad companies. But hating making a profit? That's a step too far for most investors.
After all, you need markets to rise in the end. That's the only way you will make any money.