Opportunities Created In The Markets

When The Market Gets It Wrong

Let's talk about another common misconception regarding timing the market.  I am referring to the belief  that market timers always have to know what the market is going to do.  In reality, timing the market means taking advantage of the periods of time when the market misprices assets, times when others get it wrong.  I know, in the past, the academics have said this couldn't happen, but I am not alone in saying it happens all of the time.  The price of an ounce of gold dropped around one hundred dollars the other day.  Since gold is, well, gold, are they telling me the value of the U.S. dollar, which gold is priced in, changed so much that the price of gold should correct by that amount?  It doesn't take a rocket scientist to see the price of gold was relatively overbought, meaning, relative to what people have been willing to pay for gold in the past, the price was, temporarily, too high.

Playing The Odds
Note that I said temporarily.  I don't necessarily know what the price of gold should be all of the time, but when it reaches extreme overbought or oversold conditions, the odds are it is going to revert to a point where it is less so.  As it does, it will usually begin a new trend.  If the previous trend was up, then it normally begins a new downward trend.  If it was down, then the opposite is likely.

All In
With a "buy and hold" approach to investing, we have to commit to putting all of our money in the market all of the time.  Since people using such an approach don't believe there is any method for determining the extent to which assets are mispriced, their approach is to average into the market over time.  Consistency and regularity are the key.  Their belief is that there is no pattern to the markets.  So, how is it they perversely expect markets will consistently trend higher over time(?!).  Sorry, I digress. 

Market Extremes
In the so-called timing of the markets method,  I don't necessarily care about the direction of the markets.  If gold is extremely overbought, it can correct lower, no matter what the market is doing.  As far as the price of gold goes, I don't care what it is doing most of the time, I only care when it gets extremely overbought, or oversold.  The same goes for the markets.  I don't have to know what the market is doing every day, until it gets to one extreme, or the other.  Of course, the one exception would be when a reversal is followed shortly thereafter by another reversal.  If a return to the original direction of the trend creates a situation where I start to lose money, I exit the position.  I feel no compulsion to be fully invested all of the time, I simply wait for another opportunity.

Up, Down or Sideways
During long periods of time, the market can trend sideways, rather than making new highs or new lows.  There can be significant periods of time when the market is going nowhere, or going in the opposite direction of the longer trend.  I don't need to be fully invested while this is happening.

On The Lookout
Yes, others would say, but that means you have to be watching the market all of the time.  To, that I ask, your point is what?  Whenever I have money in the markets, I should be watching.  Why would I go away and ignore what is happening to my hard-earned savings?  To those who say they don't have time, I would argue it takes all of 10 minutes to check.  If I use what I call the Basic Timing Model which uses the 200-day moving average as a buy and sell signal, there is little I need to do for most of the year.  The prices of market indexes normally cross their 200-day moving averages only once or twice a year!   

Why Pay More?
To use a shopping metaphor, timing the market is like purchasing items only when they are really, really, on sale, or selling them when they are highly over-priced.  The rest of the time I can prepare my shopping list and check what constitutes a regular price.  The regular prices don't interest me, so until I spot a really great sale, I don't need to feel like I should be spending all of the money I have available.

How often do you check what the markets are doing?

The New Investing Paradigm

Different Process; Different Result

Have you ever stopped to think why home-made bread tastes better than store-bought?  After all, it is the same basic recipe, so why the difference?  We know the ingredients are not exactly the same.  Store bread usually contains cheaper, lesser quality ingredients to save money, as well as preservatives to keep the bread from spoiling, and perhaps other ingredients to speed the bread-making process.  The process, itself, is different.  Most of us at home do not bake hundreds of loaves at a time.  While most kitchens have what is required to bake a loaf of bread, few vendors have the equipment to make all of the bread they sell.  There are good reasons their ingredients, and their processes are different from those we would follow at home.

Viva la Difference
Is institutional investing different from personal investing?  Should it be?  We are subject to so much marketing done by the industry that few people, I have met, see any difference.  The common questions I get are, "Why not give your money to the professionals?  How do you expect to do better when they have so much more in resources at their disposal?"

Ownership
One thing I know for sure, I am going to take a lot better care of my stuff than anybody else will, period.  That is especially true of my money.  We hear so many stories of people who have lost their whole life savings because of this person, or another.  Would it have happened if they could have taken a more active role in the process?  If made aware, most of us are going to put a stop to our losses at a point which is well before everything being gone. 

The Sales Game
Have you ever been to a new car dealership and hung around the smallest car on the showroom floor?  I can tell you there are few sales people who want to spend time with you since most are hoping to land the next big deal on the "super whatever" with all of the toys.  A financial plan tailor-made for us little people is basically the same one made just for everyone else like you and me.  Let's face it, you and I get to speak to the sales people, not the decision-makers.  The sales people are compensated for how much of our money they get us to hand over, not how much they, in turn, make for us.   

Size Matters
Does a multi-million dollar corporation use different financial controls than we would use for our family finances?  I would hope so.  Most of us can see that hiring a corporate accountant to manage our household books is more than just a little over-kill.  Does a whale have different feeding habits than a minnow?  Of course.  The mistake too many people make is in thinking that personal investing should follow the rules of the institutional investors.  Large institutions follow a "buy and hold" approach because they are at the mercy of their own size.  The bottom line is the sales people in the financial services industry promote buy and hold as the only alternative because they want the sale.  I know few sales people who are going to sell one thing, and promote something entirely different.

Setting Expectations
Institutional and personal investors seek a decent return on investment.  Until they lump a whole lot of smaller accounts into larger accounts, the big institutions can't afford us.  It is not cost-effective for them to treat every investment, and every account differently.  They want to make a good return, and earn a revenue stream from charging fees to cover as many of their expenses as they can.  They want us to believe normal returns are in the mid-single digits, that the game is terribly complicated, and also, that a huge investment of time and resources is necessary (to justify their fees).

A New Paradigm
I believe the investing paradigm is changing.  In the beginning, the game was entirely broker-centric.  The broker controlled the flow of information and money.  Everything was done through them.  Then, when the internet provided unprecedented access to information, the process became somewhat automated by the application of computer and networking technology.  The problem with today's model is bigger is less effective than smaller.  Too big to fail is an invention of the owners of the means of finance, meant to serve themselves and their wealthy clients.  Large industrial companies, and technology companies that grow too large in physical size can't withstand the pressure brought about by the application of technology to global markets.  You may be reading it here first, but I am saying a new future of personal investing is beginning with you and I, today.  We can outperform the large institutions if we don't try to beat them at their own game, and if we don't continue to blindly follow the rules they create for us.  We have the technology, we have control of our own money, we have access to all the tools, and we can learn to use and improve our own ability.  The last thing we should do is to want to be just like them.

"Buy and Hold" hasn't worked in the last decade.  I can't predict if market conditions are going to favour a buy and hold approach over the next couple of decades.  Are you willing to risk your future and take that chance?

Corporate Balance Sheets

Sell-Side Analysts
The sell-side analysts are busy trying to calm the masses these days.  These are the people we see on TV all of the time giving their valuations for sectors and companies.  The thing we need to remember is their job is to make certain sectors and companies look attractive enough for retail investors to want to buy them.  Since it is unlikely analysts can follow the whole universe of companies all of the time, their recommendations will often be relative to the things they do follow. 

Buy, or Sell?
For example lets pretend I am one of these analysts, and I follow the telecom sector.  Since I have to have more buy recommendations than sell recommendations (people won't buy companies with a sell recommendation), it would be easy to recommend AT&T and Bell Canada.  Normally, energy, gold, and agricultural companies do better during this time of year.  Arguably, Suncor, and Potash are likely to do better over the next few months.  As an analyst my top picks come from those companies that I do follow, even though the other one's are likely to outperform, or have better valuations.

Buy & Sell Strategies
That is how, in 2008, we went from everybody telling us not to sell, to everybody telling us it was too late to sell, practically overnight.  Now I am not saying that what we are currently experiencing is on a par with the last financial crisis, but I don't look to the analysts to tell me when to sell.  I have a buying strategy, and I have a selling strategy, and I follow them as the markets gyrate up and down.  My strategies allow me to make money even in down markets, and they also allow me to sleep at night.
   
Recession, What Recession?
I am not sitting in judgement of the analysts, just saying that is what they do.  So when we hear them saying there is no risk of a double-dip recession, and they are all saying it, I start to get cautious.  First, when everybody seems to be taking the same side of the argument, that is a caution sign.  Second, when they say the reason we can't be headed into recession, again, is because of the pristine balance sheets for almost every company across North America, my intuition kicks in.

Spending
Around seventy percent of the U.S. economy depends on consumer spending.  Just over 10 percent comes from corporate investment.  That would imply that for every dollar consumers don't spend (because they can't spend what they don't have), corporations would have to increase their spending by seven!  Why would companies do that in the current environment?  Given the uncertainty, the lack of consumption, and the difficult economic environment, what would cause U.S. companies to go on that much of a spending spree?

China
While China is seen as saving the world economy, the U.S. imports almost four times as much from China as it exports to China.  How are U.S. companies going to make up for the lack of sales of imports (i.e.: lack of consumer spending)?  China, basically, imports from other Asian economies, and exports to the U.S..  Reversing that flow isn't suddenly going to happen.

Advanced Planning
I try to keep in mind that most of what we hear in the media is "sales talk".  I should determine, in advance, the conditions under which I should buy and those under which I should sell.  That will prevent me from being at the mercy of the sales pitches and the obvious but irrelevant arguments constantly playing out in the media.

Have you formulated your buy and sell strategies in advance?

         

Jim Cramer On Why Price Matters



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Fact, or Theory?
TV host Jim Cramer calls the notion that investing requires a "hands off" approach, one that ignores short-term volatility,  a myth.  He advocates taking advantage of those short-term fluctuations to buy good companies cheap and sell them when they get expensive.  (Never mind the efficient market hypothesis - see previous post - that says that should be impossible).  He says the risk profile of holding a stock changes as the price changes.  He also says the market correction of 2008 has convinced him, more than ever, that "buy and hold" does not work.

His advice is price matters.  Who should we believe, the academics labouring over elaborate models with which they hope to support their theories of markets they don't totally understand, or the ex-fund manager, who made himself very wealthy by following his own common-sense advice? 

Who do you believe?

A New Risk Paradigm

Risk-free?

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In this interview with Ann Rutledge, she states that the financial concepts she studied at the University of Chicago were predicated on the notion of a risk-free rate.  With the Standard and Poors downgrade of U.S. debt, that notion becomes, in her words, a myth.

Same Asset; Different Risk
She thinks that if the U.S. debt is not risk-free, as was previously assumed, then it would be possible to use more than one model to determine asset risk.  If different people use different models with different assumptions, then that means there is no longer only one answer (as assumed for efficient markets theory because the efficient market theory assumes the market is aware of the information used to price an asset, so the price has to be correct since that information is known).

How Real Markets Work
I have always found that logic to be what is called "circular logic" in computer programming, but has been highly followed for many years.  If what Ann is saying is correct, then I take it to mean that different people, using different assumption would be willing to pay different prices for the same asset.  This sounds more like a real market to me.

This means the market does not always get the price correct, that the market is capable of mispricing assets.  This would also mean we can take advantage of situations where the market has mispriced an asset by buying low and selling higher.

Which Leads To...
To me, this is a perfect example of how the academic models, touted and flouted by the financial services industry as proof that "buy and hold" is the only approach that might possibly work, will continue to be disputed by actual experience.  It would prove that timing the market is more than merely being lucky, as they have tried to lead us to believe.

What do you think?  Might the financial services industry use out-dated academic models to support their "buy and hold" position?

High Frequency Trading

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High Frequency Trading (HFT) was the likely cause of the May 2010 "Flash Crash".  I took the event as a sign of instability in the markets and sold everything I had which was long (trending with the market).  More than a year later, the regulators appear to be in the pockets of these organizations, and don't see a reason for making changes.  Perhaps they believe that market "circuit breakers" will prevent any crashes from occurring.  I am not so confident.

For me, there are three take-aways regarding this issue.  The first, as Jim Cramer says, is I invest only in strong, liquid (largely traded), best of breed companies and Exchange Traded Funds (ETF's) although I don't sacrifice all of my potential growth by holding only dividend paying companies.

The second is, I don't use hard stop losses.  These are sell orders which are automatically triggered when the price of the security reaches the specified limit.  I know what my sell price is, and place a limited sell order when my investment reaches my target.

Notice I said limited sell order?  The third thing is, I do not use market orders, but limit the price which I am prepared to pay.  This applies to buy and sell orders.  There are other reasons for taking this approach, but HFT provides me with the biggest reason to do so.

Until the regulators choose to see High Frequency Traders for what they really are - stock market spammers - I can't afford to ignore the potential damage they can cause to my portfolio.

Has recent events caused you to make improvements to your approach?       

Position Size

80/20 Rule

Decisions, Decisions.
Size matters, or so I am told.  From "too big to fail", to sports like boxing, size is a factor.  The question is, how does size affect one's investment portfolio decisions?   For those who don't have a sell strategy (i.e.: Buy and Hold) diversification is the only hope, and what follows will be of little use.  Having a sell strategy provides me with a few more options.

Call Me Arrogant
First, I have heard it said that buying a whole position all at once is the dominion of the arrogant.  That may be true if we are not using technical analysis to time our entry points.  My method of determining when to buy has proven to me that what I call a buy signal is just that - the point in time when the odds are most in my favour.  Averaging into the market almost always reduces my returns, it does not improve them.  If I buy all at once, and I am only partially right, then I can begin to reduce the size of my position.  If I am completely wrong (read: losing money) then I sell everything I just bought.  I would rather be out the commission than lose capital.

Diversification
Next, we should talk about the size of a position.   I have seen academic studies that demonstrate even twenty stocks is not enough for any one portfolio.  (That study was probably commissioned, pardon the pun, by the financial services industry - cha ching!)  Note that a single broadly based Exchange Traded Fund (ETF) can contain well over the twenty stocks required to provide me with enough diversification.

Market Correlation
What I am saying is holding broadly based ETF's provides me with all of the diversification I need, thank you, even if I put my whole portfolio into one ETF!  "Wait!" the experts will say, "You need diversification between various regions of the world!"  Do you hear the cha ching in the background, again?  Since I have a sell strategy, if my investments in the TSX are under performing, when I do sell, nothing says I have to buy the TSX, next time around.  Understand that markets around the world are highly correlated, these days.  By that I mean when one market tanks, the others are likely to do so, also.  Maybe not at exactly the same time, but close enough.  

80/20 Rule
Having said all that, I believe in the 80/20 Rule.  Applied to investing, the rule tells us that 80 percent of our returns will come from 20 percent of our holdings.  Rather than watering down my returns by casting my money into everything in every market, I use seasonality, technical analysis, and fundamental analysis, to focus on the areas of the market that are working, and simply forget about everything else until the conditions change, again.

Returns
The major lesson the market has taught me is I don't have to have all of my money in the market all of the time.  I used to think I was wasting opportunities by not being all in!  Nothing could be further from the truth.  If I divide my portfolio into five, how much of a return do I need to make 20 percent, over all?  You get it, I still have to make 20 percent each time.  Each fifth of my portfolio that makes 20 percent contributes 4 percent to my overall results.  Do that five times, and at the end of the year I end up with 20 percent.  Or, I can make 10 percent on any one position (each time contributes 2 percent), and do that 10 times, and still end up with 20 percent per year.

Better Than Average
Do you get what I am saying?  I only need to have 20 or 40 percent of my portfolio in the market at any one time, and as long as it returns 10 percent in a month, or two, I can take two months of the year off, and still make a twenty percent return.  Not bad, when the average annual rate of return for the markets is around 8 or 9 percent! (Which, by the way, most active fund managers fail to do over the longer term, after expenses). 

Sleep Tight
I am not saying this is what you should do with your own portfolio.  I am not qualified to give that kind of advice.  I am saying, with practice, and experience, it is possible.  Consider the possibilities that not having everything in the stock market all of the time creates.  If nothing else, it helps me sleep better, especially in these crazy markets!

How do you decide how much to put into any one investment?

Portfolio Update

Click To Enlarge Chart

My July results find me caught back up to the market, or perhaps I should say the market caught up to me.  I enjoyed some success in the energy sector before the last week in July when everything reacted to the political games in the U.S..  As a result, the charts signalled at least a short term reversal, so I bought the inverse S&P 500 ETF.  The latter provided me with the largest amount of my profits. 

I have not given up on energy, as we have entered a seasonally strong period for it.  I am also watching gold, but hoping for a correction in order to find a good entry point.  Agriculture and natural gas are also beginning their strong seasonality. 

Apparently, we have had too much rain for natural gas to be of great interest, at least according to one analyst.  He suggested that natural gas is used to supplement electricity needs.  So, despite the heat waves we have seen over this summer, water reservoirs are filled sufficiently to provide enough hydro-electric power that we do not need large quantities of natural gas for power generation.  Huh, who knew!

If you are wondering about the reversal in XIU in my chart, it is because, as a market timing tool, we would not hold it below the 200 day moving average.  Since the 200 d. m.a. was still rising in July, selling XIU at it's latest cross downward through the 200 d. m. a. protected profits from earlier in the month.

Seven month return for TSX @ July 31, 2011 = -3.51 percent
Seven month return for Basic Timing Model using XIU = -0.98 percent
Seven month return for Advanced Timing Model (my returns) = -2.35 percent
Money for charity = $411.27

Anyone want to share their returns for the year?