Harness That Volatility

Volatile markets are very disconcerting. Investments can decline in value very quickly, and paper gains can disappear in short order. During selloffs, new buys can look dumb, and anything that you had been considering selling may look like a lost opportunity to lock in profits. The flip side is that, when the market rallies back, any sales or decisions to reduce equity exposure look foolhardy. Hesitations to put cash to work during the selloff suddenly become huge lost opportunities.

Last week we highlighted the sizeable bounces that a number of stocks have experienced from the recent lows, with many stocks up 10% to 15%.

As volatility is a fact of life for equity investing, the key is to try using the volatility to your advantage.

Some basic rules apply.

First, turn down the volume. While it's very important to keep posted on current events, try not to get overly upbeat or downbeat about the news. Listening to the news in the past few weeks has been and will be very worrisome, but knee-jerk reactions to the headlines has been very costly.

Try to set a long-term commitment to stocks, and outside of extraordinary circumstances, we believe you should stick with that plan through the market's ups and downs. Having an asset-allocation plan that you are comfortable with, in good times and bad, is the single most important investment decision you will make. The market selloffs this year, which included those sparked by the Russia-Ukraine conflict earlier this summer and the Ebola and European/China economic scares since mid-September, fall into the "ordinary" circumstances.

Within the framework of your long term commitment, be more aggressive in your equity commitment after selloffs. In the current environment, we would add to stocks on every 5% drop, seeing as we think the general underpinnings for stocks are favorable.

The flip side is: Don't be shy about taking a profit in individual stocks or in the market as valuations get stretched. Don't fall in love with your winners, in other words. As a particular stock approaches a 20x-plus price-to-earnings ratio, use 100- and 200-point rally days to lock in a profit. At the moment we are comfortable with the S&P 500's overall valuation at 16.5x 2014 projected earnings, and 14.9x 2015 estimates.

Most important, in terms of day-to-day swings, try to take advantage of the most violent of price moves. If you like a stock and the market is selling off on European stress-test results or new Ebola cases, have the courage of your conviction and buy into the weakness. Prices seem to be getting unduly hit, but programs and ETF sales are likely adding to the day-to-day volatility.

A quick current example: Goldman Sachs downgraded its forecast on oil prices for 2015 to $75 per barrel. Oil stocks got slammed on Monday's open on this news, and oil is falling below $80. Two stocks that we think are great buys here are Devon Energy (DVN) and Schlumberger (SLB). So we would look at a $3-to-$4 gap opening in each as an opportunity to buy in. Schlumberger in particular had a great earnings release and outlook just last week. Buy this selloff.

Finally, within the framework of having equity exposure, buying a diversified basket of higher-yielding stocks should allow your portfolio to ride the ups and the downs with much less volatility. Ultimately we expect a basket of these higher-yielding stocks to have reasonable growth over the next six to 12 months, and investors are getting paid a nice income stream while they wait.

At the time of publication, Matrix clients and Katz were long DVN and SLB.