Market Timing Myths

Not For Everyone
Another of the myths about market timing is, if market timing actually worked, then everybody would be doing it.  If you are familiar with my blog, then you know the main reason this is not true.  Personal investors do little to influence market direction.  It is the mega-sized orders of the large fund managers that determines the direction of the markets.  It is the very size of their positions that prevent them from jumping in and out of the markets.  It takes a period of days and weeks to either establish, or eliminate their market positions.  For them, market timing is not a viable option.

One Size Fits All?
So, if it doesn't work for the professionals, then it can't work for the little guys, right?  That is like saying the route I choose in a dinghy has to be the same as that of the captain of an aircraft carrier.  As for me, I would not attempt to cross the ocean in a dinghy, just as I would not try to pilot an aircraft carrier down the local river.  While the purpose of the boat determines its size and dimensions, the size and dimensions of the boat also limit how it can be used.  That is not to say professionals do not use charts to help them make portfolio decisions.  Fund managers use every tool in the shed, including technical analysis.   

How Popular?
If it works best for personal investors, then why don't more of them use it?  One reason is financial institutions want people to think they are unable to manage their own portfolios. If people believe they are unable to do it for themselves, then they have little choice but to hire a professional.  Yet, I am willing to bet practically every nurse on the planet can read a chart, so, why not a stock chart?   

References
Another reason people won't time the market is because is doesn't work for them.  While that may seem like a perfectly good reason, we have to wonder why it doesn't work.  It actually is not because timing the market does not work, it is because most people are, well, people.  Given to emotion, most people buy high, and sell low - just the opposite of what they should be doing.  As a result they label timing the market as being too hard, even impossible.  Their inability makes it clear to them that market timing, simply, does not work.

Denial
Yet another reason everyone does not try to time the market is because of something called denial.  Not a lot of people want to believe that group behaviour is, in some way, predictable.  We see ourselves as acting independently of those around us.  After all, we have a mind of our own.  How dare anyone suggest our decisions are similar to that of many others despite the fact their situation may be similar to our own.  Denial is far more than just a river in Egypt.

Either/Or
I have never understood why, but there is another whole segment of investors who believe technical analysis precludes any sort of fundamental analysis.  One taints the other.  I say, why work with only one hand, when we are perfectly capable of using two?  The result of using one technique should complement the use of the other, not contradict it.

Bottom Line
We can see there are all sorts of reasons why everyone will not embrace technical analysis and market timing.  The belief that everyone needs to is yet another example of the misinformation surrounding the real issues.

Convinced?  Should market timing be expected to work for everyone?  

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?

The "Social Media" Investing Model

Good Advice
I was doodling on my note pad at the Social Media seminar I attended earlier in the week.  It occurred to me the advice we were receiving would be useful for those wanting to learn more about investing.

Learn/Listen
The fastest way to learn anything (other than from adversity) is from other people's experience.  Since there are as many investing strategies as there are people, look for the classics like "The Intelligent Investor", by Benjamin Graham, "Stocks For The Long Run", by Jeremy Siegel, "The Wall Street Journal Guide To Understanding Money and Investing", by Kenneth M. Morris.  I like "How To Make Money In Stocks", by William O'Neil.

Technical Analysis has increased in popularity of late.  I recommend achieving an intermediate (as opposed to beginner) level of understanding.  Search Amazon, and look for something of interest.  I started with Stan Weinstein's "Secrets For Profiting in Bull and Bear Markets".  The investing world is divided between fundamental and technical investors.  Why rely on a monaural approach when we can enjoy the advantages of a fully enhanced stereo experience?  I suggest using fundamental analysis to determine what to buy, and technical analysis to identify when to buy. 

Set Goals
Do you want to become independently wealthy?  Do you want to supplement your income?  Do you want a fully paid vacation?  Remember, goals should be SMART (Specific, Measurable, Achievable, Realistic, Time-sensitive).  Consider setting short-term goals based on longer term ones.

Practice
Paper trade.  There are sites and contests on the internet which allow us to buy and sell stocks using practice accounts instead of losing real money.  It is rather like learning to ride a bike.  We are bound to fall and get a few scrapes before we can hold our own at the Tour de France.  Understand, however, paper trading only goes so far.  There is nothing like the feeling of losing significant amounts of money in a bad trade, or the excitement of riding a huge gain.  Learn to set limits based on the level of personal experience.

Participate
Keep accurate records.  Use those records to identify what works for your situation and what doesn't.  Do more of what works and less of what does not.  What works in some situations will not work in others.  Nothing in investing works all of the time.  Anyone who says otherwise is lying.  Be prepared to shorten time horizons, or lengthen them.  Trade more; trade less.  Never fall in love with an investment, or a trade.  They all have their day, then, can turn on us in a heartbeat.  Investing is like public speaking; getting too comfortable or too lazy is usually a mistake.  Anticipate various scenarios and plan appropriate responses.  Plan ahead, do not react.  Instinctive reactions are necessary for survival; they usually go contrary to good investing practices.

Measure
Measure progress toward goals.  Make improvements without relying only on the advice of others.  Investing is like playing poker.  People come to the table with their own agendas and strategies.  If their real agenda is consistent with what you are attempting, then fine.  Understand that nobody in the Financial Services industry wants to make you money if it interferes with how they make their money.  Also, understand that they almost never get paid based on the amount of money they make for you.  If that were the case, there would be a lot of starving workers in the industry.  Ever wonder how companies can afford to pay those huge bonuses?

The advice for determining the percentage of equities in a portfolio based on age is only a guideline.  Revise your goals based on your results and your desired results based on your goals.  I know that sounds like double talk, but just like fundamental and technical analysis, we are not limited to one instead of the other. 

Repeat
I started out in the safest of mutual funds, then sector funds, then Exchange Traded Funds (ETF's), then leveraged funds, then individual stocks.  I will be trying my hand at options when I open my first Tax Free Savings Account (TFSA).  Each time I found myself repeating the process.   Sometimes it is necessary to repeat the process because of a change in goals, or because of differing results.  It took me a long time to determine what works and what doesn't, and that wasn't for a lack of asking questions - I rarely received straight answers.  According to the industry, we are not supposed to do it ourselves ("Doctors don't operate on themselves!"), and we sure as heck are not supposed to time the markets ("It is time in the markets, not timing the markets!")  I invite you to take advantage of what I have learned.  Use me as your resource.  I love doing this stuff, it is what I do, and I am more than happy to share what I do with others.

Have you followed a similar approach?  How do you test your ideas?
    

Technical Analysis - Research In Motion



Click to Enlarge



Troubling Chart

Despite the fact that, fundamentally, Research In Motion appears to have value at current prices, the chart points out a significant problem.  The weekly chart shows the stock has been in a multi-year downward trend.  The region between the green lines I drew on the chart is known as a trend channel.  The closer we get to either boundary, the greater the chance of a reversal.

While the chart does not indicate RIM is a good longer term investment, buying at a reversal near the bottom of the channel could result in a healthy shorter term profit.  What does not appeal to me about this option is where the channel leads in relation to the blue line which appears close to the top of the channel.  That line represents the 200-day moving average.  It is the result of the average of the preceding 200 days, and the average of the preceding 200 days one day prior to that, and the average of the preceding 200 days one day prior to that, and so on.  I always hesitate to own stocks which are trading below their 200-day moving average because they have a greater probability of downside surprises.

Technical Indicators

For most people, it would be too lengthy to go into an explanation of all of the technical indicators I use.  The ones I rely on include Volume, Moving Averages, the Relative Strength Index, Keltner Channels, Percentage Price Oscillator, and Stochastics.  For more information on these, I recommend http://www.stockcharts.com/.

For more of an introduction to Technical Analysis, my favourite is an older classic called Secrets For Profiting In Bull And Bear Markets by Stan Weinstein.  It is a well written book that covers the basics.  I had thought it was out of print, but recently found it to be available on Amazon.  Investigating the Stockcharts website listed above can help in understanding various technical indicators and overlays not covered in that book.



I have also recently read Trend Trading for a Living by Dr. Thomas Carr.  I like the way in which he steps his readers through his process, step by step by step.  This is for more advanced traders, as he also describes his methods for options trading later in the book.  Even without the parts on options, the information is quite helpful.

Not This Time

For now, the technicals are telling me I should not be buying Research In Motion for my portfolio.  That's okay.  While there are not that many tech companies in Canada the likes of RIM, there are many, many good, growth companies I can make money with.  I like great companies I can invest in, but I love great companies whose shares are at the extremes of what they should be selling for when the charts are signalling the start of a new trend.  That is the advantage gained by combining Fundamental Analysis with Technical Analysis.  

Fundamental Analysis - Research In Motion

Price = Earnings X Avg. P/E Ratio

Fundamental Models
I love how analysts will go to incredible lengths in trying to figure out what the stock of a company should be worth.  They use mathematical  models that would give a genius pause.  These models are usually the product of decades of research into market behaviour.  Most are proprietary - they wouldn't want anyone else to steal their secrets gleaned from day to day experiences in the markets.  How could we, for even a second, believe that we could ever hope to understand prices when it has taken them a lifetime?  Why even try?  Until, that is, we read the line that says, "Past results cannot be used to predict future performance."  Huh?!?

The truth is, nobody has ever developed a model that works in every type of market every time.  In fact, nobody has ever developed a model that works in most markets most of the time.  I believe the reason these models are so complicated is because every time something goes wrong with the model, it has to be updated and amended so that, next time, they won't make the same mistake.  Still, there is no forecasting the markets.

Having said that, we need to understand that trends develop in the markets.  After all, markets are the product of human interaction, and we know how people can develop a herd mentality.  What that means is while prices may be affected by people's perceptions of different events as they occur, prices tend to follow a trend for periods of time.  This is huge when it comes to technical analysis, but it can also be used in fundamental analysis. 

Calculating Price
I have blogged earlier about Price/Earnings ratios http://ianbrennan.blogspot.com/2011/03/price-earnings-ratio.html as a means of calculating a fair price for any stock I might want to own. Studying the trend in RIM's Price/Earnings ratio over the past number of years, I feel comfortable using a value of 10.  If anything, 10 would appear to be low, given the growth rate of the company in recent years.  By using a value of 10 I am saying that I am willing to pay 10 times annual earnings for a share in RIM.  For a company growing at the rate that RIM has, and is, most people would normally be prepared to pay much more.  Using the guideline of never paying more than twice the growth rate of the company, that would suggest RIM is only going to grow somewhere between 5 and 10 percent next year.  Given the company's past performance, this is clearly a conservative estimate.

Annual mean earnings for the fiscal year ending February 2012 are estimated to be $6.91.  Earnings of $6.91 times an estimated Price/Earnings of 10, gives us a price of $69.10.  Given the current price as at the end of April 28, of $53.83, that would give us a potential up side of $69.10 - $53.83 / $53.83 = 28 percent!

That's It?
Can it really be that easy?  What about management, products, cash flow, and all that stuff?  Think of it in this way.  Let's say we want to buy a new car that is reliable and has better than average gas mileage?  Should we pay more than a similar car that is not reliable?  Should we pay more than a similar car with poor gas mileage?  Should we pay more for a car that is popular - one which people are happy to own?  While there are other considerations (whether, or not, the company is going broke), we can see in this case that we are looking at a company which can offer a better car, hopefully at a fair price.  What we need to know about the company is baked into it's history of being able to offer a better vehicle at a better price - one which people enjoy owning (assuming that is the case).

Would the company continue it's favourable history if it was poorly managed?  Would that likely be the case if they had poor quality control?  Would that likely be the case if the company was not offering value to it's customers?  I'm from the school that says if it quacks like a duck, it looks like a duck, and it acts like a duck, then it is probably a duck!

How fast the company is growing is reflected in the earnings estimates and the historical Price/Earnings ratio.  The same for management, and competition, and financing, and inventory, and on, and on.  What that also means is I only buy reliable companies (one's with a consistent history of earnings - which also means they are making money).  Still, I don't just blindly follow earnings estimates.  They will be too high going into a market correction.  I watch for earnings revisions on any company I own, or want to own, and know that analysts don't usually anticipate future market corrections.

So, with a potential, conservatively estimated gain of 28 percent, then RIM is a buy, right?  Well, not so fast.  Next time we look at the trend in RIM's price before I put in my order.

Can you see how I use earnings and Price/Earnings ratios to help establish a price target?  Do you use price targets? 

Research In Motion

Who Is Right?
It seems Research In Motion (RIM - TSX) is in all of the Canadian media these days.  With the release of its new Playbook tablet, there is no end of debate as to the future of this company.  It seems there are strong arguments to be made both for and against owning stocks in this company.  In fact, there seem to be as many opinions as there are analysts who follow this company, and there are over 50 who do.  Despite all of those opinions, sentiment seems to be split pretty much down the middle, for and against.  Does that mean investors should just let the dust settle before deciding whether or not to own shares in RIM?

Fundamental, or Technical Analysis?
I am not a professional, so, as I keep saying, I cannot advise people as to which companies they should own, or not.  However, I think this would be an excellent opportunity for me to reveal the process I follow when evaluating a stock for my own portfolio.  Some people prefer to rely on fundamental analysis, where the company financials are dissected and numbers crunched.  Others prefer a technical approach, instead, analyzing charts of price patterns. 

Why Not Both?
Personally, I have never understood why it has to be one, or the other.  Why would anyone try to do their best work by, first, tying one hand behind their back?  I understand why some people prefer one method over the other, but something I learned a long time ago was to solve a problem using one approach, then check the result using a different approach.  This can create a situation which reinforces the old proverb that a person with a watch knows what time it is, while a person with many watches can never be sure.  In other words, what to do if the fundamentals and the technicals do not agree?  My advice is the same as any situation when there is too much uncertainty - don't buy!

What To Buy and When To Buy
In fact, I use both approaches because I am actually trying to determine the answer to two different questions.  The first question is what should I buy, and the second question is when should I buy?  I do not simply buy stocks in fundamentally good companies and wait for something to happen.  I use the price charts to determine whether the stock is in an up trend, or not.  I don't believe in purchasing a stock where the share price is losing money, because my first priority is preserving capital.  Neither do I like to have money sitting in stocks that are not performing.  There is an opportunity cost to tying up money that could otherwise be earning a return.

When To Sell
Buying a stock with a price that is in an up trend is fine, but how do we know how long to hold it?  We can simply hold the stock until the trend breaks, but there is a chance of leaving money on the table.  Stocks rarely rise in a perfectly uniform trend line.  The purpose of having a price target is to increase my probability of selling at the best time.

Next Time
Next time I will describe the process I use to determine my price target.  Whether the analysis is fundamental, or technical, the principle is to buy stocks when the price is low and to sell them when the price is higher.

Do you have a preferred process in determining what stocks to add to your portfolio?  Do you have a sell strategy?

Fundamental AND Technical Analysis

Tools of The Trade
Orienteering is a sport that requires competitors to find flags hidden outdoors by using a map and a compass to navigate a course. The map shows the contours of the terrain, and uses different colours to illustrate the type of ground cover - trees, clearings, water.  The compass is used to orient the map and to guide the competitor in a particular direction. Close to the flag, the use of the map is crucial in pinpointing its whereabouts. The course could be navigated with only the map or the compass, but it would usually take longer because it is much easier to make navigational errors when not using both.

Fundamentals or Technicals?
When I hear advisors who say they rely on the fundamentals and others who say they rely on the technicals, I often think of orienteering. Why would they want to rely on only one, or the other, when both are available to them? I suppose we have all heard the expression, "Jack of all trades; master of none," but we don't need university degrees in either area to use them effectively. We don't need to know every last detail. I think we can all agree that knowing how many pennies the CEO has in her purse, is detailed, but useless information. Likewise, knowing the number of years in a row a stock has made an uptrend in the month of September is, for the most part, of little value.

Done properly, fundamental analysis tells us what we can reasonably expect to pay for a share in any company. Likewise, technical analysis can tell us whether we are close to the beginning, or the end, of any trend in the price. Armed with that information, alone, we can make intelligent decisions about what to buy and when to buy it.

Why Not Both?
I continue to hear the talking heads proclaim they are a fundamental, or a technical sort of person - and proud of it. I understand the two types of analysis represent a different approach and mindset. They are two different ways of looking at companies. That is the strength of using both types of analysis. If they both confirm a buy decision, then great. If not, then why risk it? Would you recommend a dentist who only uses half of their tools? Imagine your dentist saying, "I don't do x-rays because I don't find them very helpful!"

The problem is the two approaches are seen as either/or instead of both/and. The fundamentalists cast dispersions on the techies claiming how much more thorough their analysis is. The technical analysts claim the fundies are not even necessary. Yet, it is not the type of analysis, which is important, but the information that each yields about any potential investment. Unless, of course, we assume there is no use trying to buy at a low price because we are almost never going to sell, anyway.

The Bottom Line
So there is the rub. Why give credence to any tool that flies in the face of the sacrosanct buy-and-hold marketing strategy? Funny thing is, I'm willing to bet that most fund managers actually pay attention to moving averages and other technical signals. It would likely have a negative affect on returns if they didn't. Doesn't it go to follow, then, that the very existence of technical analysis would dispute the notion that it is impossible to time the markets? Unless, of course, technical analysis is just a lot of creative imagination.

What do you think? Which is for real, technical analysis, or buy-and-hold?