The Seduction of Market Timing

Here is the dirty secret about market timing: Claims of success are exaggerated — big time!

Every investor wants to buy the bottom, and (especially) to sell the tops. This is so deeply craved that investors want to believe it is possible. In the wonderful world of financial news, this defines the opportunity.

The best sales approach is to claim expertise in market timing. This often means citing a single dramatic moment:

  • Predicting one of the various bubbles is an especially great credential. It is especially humorous when the expert is introduced as being an "early" forecaster of housing problems. There were many who qualified on that front who did not have good investment results over the entire cycle.
  • Calling the bottom in 2009. There were a series of nominees on this front as well. Someone was calling a bottom nearly every week, and there were a few big winners.

A Brief Digression for a Small Quiz

Anyone who follows financial media is a consumer of market punditry. Here are some regular pundits. How would you rank their market-timing advice? Just put a number next to the name.

Pundit
Ken Fisher
David Dremen
Louis Navellier
Laszlo Birinyi
Doug Kass
Marc Faber
Bernie Schaeffer
Jim Cramer
Stephen Leeb
Jim Jubak
Charles Biderman
Bill Cara
John Mauldin
Gary Shilling
Bill Fleckenstein
Abby Joseph Cohen
Peter Eliades
Robert Prechter

The Current Question for Investors

The average investor is too easily swayed by smooth-talking experts on TV. I want to discuss this in two parts — some observations I made in 2010 and then an update on current issues and pundits.

Here is the key point:

Learn to distinguish between market commentary and specific investment advice!

When Warren Buffett (or Jeff Miller) provides a market commentary, it is not intended as investment advice. It is a general market observation. Anyone who starts by saying that "he got me out of the market in 2008" or "he got me invested in 2009" is making a mistake. This is not the right way to think about your future.

Your investment program should be like a made-to-measure suit — just for you.

I went on to suggest the following advice:

For retirement clients I consider five different strategies.

  • A bond ladder — near-term instruments roll off and we go out to the end of our time frame, currently eight years. This leaves us less sensitive to increasing rates. this is very important right now.
  • Dividend stocks. I emphasize the stock-picking part of this. Buying a poor stock with a good yield is not the answer.
  • Covered calls. Writing calls against stock positions adds to income. If you do a good job of picking the stocks and which calls to write, this can be a major boost to yield. I have a method combining fundamental and technical analysis. It is not just a matter of finding the highest premium.
  • Stocks. Yes, stocks belong in the portfolio of nearly everyone. You are never too old to own a great growth stock.
  • ETFs. A disciplined ETF strategy should be part of nearly every portfolio. There is a need to establish rules and to follow them.

So the key point is that you should not go "all in" or "all out" because of something you read or see on financial TV.

Quiz Answers

With this in mind, let us return to a review of forecasts. These are the people that you read in the financial press or see on TV. The principal credential offered is that they are often quoted or on TV!

Wouldn't it be nice to know whether famous pundits had a good track record? One of my missions at "A Dash" is to find the best experts. Beware of those who pretend expertise that they really lack.

A great source for track records is CXO Advisory. This source is objective and strong on research methods. The guru grades page shows the public record of many of the people we follow. You can check out the individual analysis to see exact public statements and the interpretation. I strongly recommend frequent visits to this site. But let us check out the quiz list. I made it easy by listing them in order of success.

Pundit scores

 

The first thing we should note is that most pundits bat less than .500. The second impression is that, with the exception of Cohen, the doomsters are at the bottom of the list. This is surprising given that the decade featured includes some of the worst performance in history.

Analyzing John Hussman

CXO does not have a grade for John Hussman because the story is too complicated. Hussman has had reasonable returns — not as good as the best of us, but with lower volatility. The key thing to understand is that he provides no edge in market timing, and that is where he gets his major publicity.

Most recently he writes that this is one of the worst times to invest, and he is featured in Barron's and widely cited. Here is Josh Brown's summary. Regular readers know that I do not accept his methodology or his conclusion, because he creates after-the-fact models and excessively tweaks the various parameters. He then adds a layer of dense prose that prevents anyone from explaining what he has done. None of it is peer-reviewed. It is simple data mining, creating a "syndrome" from known results – impossible to disprove.

But put aside my conclusion, and turn to an independent review. Hussman is easy for CXO to analyze since he has a fund with a public track record in addition to his statements. CXO does a careful analysis. Here is the conclusion:

In summary, while hedging has generally been advantageous for equity investing over the past 11 years, evidence from simple tests provides little support for a belief that John Hussman successfully times the stock market via hedging adjustments based on his assessments of market valuation and market action.

Note that this review was done before the recent market rally, where Hussman again has been wrong. The review explains that whatever risk-adjusted advantage Hussman gains comes from stock-picking, not market timing. For consumers of his regular market commentaries, this is bad news.

Conclusion

I often feel lonely in offering the most important advice for investors:

  1. Asset allocation is a personal decision, based upon your own circumstances.
  2. Find a plan that fits your investment time frame and needs.
  3. Don't think that there is a magic system to time the market.

My own methods reflect potential gains and risk, the classic investment tradeoff. Meanwhile, exaggerated reactions to news occur constantly. Beware.

UPDATE 3/24/12, 10 AM CDT:  The original post had a typo giving an incorrect score to Marc Faber.  Thanks to reader JM for pointing this out.  I apologize for the error.

A Weighing the Week Ahead: Seeking Safety?

If you are looking for safety, you are not alone.  Many people who lost money in stocks and real estate have become more risk averse.  The problem?

They are looking for safety in all the wrong places!

Owners of (formerly AAA-rated) US debt experienced this last week.  If you own a ten-year Treasury note, you lost 2.5% in market value as the yield increased 30 basis points in a few days.  What if the yield moves to 3%, a level that is still quite low by historical standards?  That would cost another 6%, or more than 8.5% in total.  You will still get your investment back if you hold until maturity, but I suspect that many seeking safety might need access to these funds in the interim.  (Check here to learn about bond pricing and use a free online calculator).

The same is true for bond funds, where the long bull market has created the impression that values can move only one way.

Gold investors also took it on the chin last week, losing 3.3%.  Gold is attractive to two distinctly different camps:  those expecting rampant inflation and those predicting a gloomy deflationary spiral with desperate consequences.  Sometimes the sellers of gold (and fear) offer both propositions — either in the alternative or simultaneously.  Two years ago I described these as the "golden goal posts."

Right now the prospects for either alternative have been reduced, making gold less attractive.  Since there is no fundamental method for valuing gold, the presence of these fears makes the difference.  Right now the fear trade is not working, since the ball is going through the uprights.

I'll offer some suggestions about the search for safety in the conclusion. First, let's do our regular review of last week's news and economic data.

Background on "Weighing the Week Ahead"

There are many good sources for a comprehensive weekly review.  I single out what will be most important in the coming week. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.

Unlike my other articles at "A Dash" I am not trying to develop a focused, logical argument with supporting data on a single theme. I am sharing conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am trying to put the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad.  Often there is "ugly" and on rare occasion something really good.  My working definition of "good" has two components:

  1. The news is market-friendly.  Our personal policy preferences are not relevant for this test.  And especially — no politics.
  2. It is better than expectations.

The Good

The news was mostly good last week.

If strategists as a whole were particularly prescient, this would be a bearish sign, but fortunately that's not the case.  The peak recommended stock weighting came just after the peak of the Internet bubble in early 2001, while the lowest recommended weighting came just after the lows of the financial crisis.

  • Tame inflation data.  As measured by the government, inflation is under control.  The Fed seeks 2% inflation as a target consistent with its dual mandate of price stability and full employment.  The current policy is designed to increase inflation expectations to that level to avoid what economists call a "liquidity trap."  While many disagree with the economic theory and the policy, investors should accept the reality.  Doug Short provides this fine chart of long-term inflation, as well as a discussion of some of the alternative viewpoints.

Inflation-1872-present

  • Initial jobless claims returned to the 350K range, the lowest since 2008.  Calculated Risk has a helpful chart.

WeeklyClaimsLongMar152012

 

The Bad

There was also some bad news last week.

  • Budget deficits.  The Obama budget has higher near-term deficits according to the CBO.  This is a complex subject, since there is a trade-off of near-term deficits versus long-term savings.  There are also assumptions about whether or not the Bush-era tax cuts are extended.  Finally, we have ongoing debates about the debt limit compromise and whether one side or the other will look for a way to weasel out.  Stay tuned! 
  • Consumer sentiment (via the University of Michigan) is weaker.  This was lower and missed expectations.  I place a lot of emphasis on this series because of the excellent methodology, not because it is my school. This series usually informs us about employment, but currently includes political effects as well as high gas prices.  Despite the issues, I regard this as important information and a cause for concern until it gets back to normal levels.
  • Industrial production was flat, missing expectations.  There was only a small market reaction, but this is one of the factors followed by the NBER in dating recessions.  Steven Hansen has a more positive take, focusing on manufacturing and de-emphasizing utilities.  Here is the key chart.

Z-ip5

  • More estimates on the impact of the Iran situation on the price of gas.  This is worse than I have been citing, possibly as much as $6/gallon.
  • We are at a "Bradley turning point."  Ordinarily I would not even mention this, but it is the latest cause celebre of the bearish punditry.  Two of my favorite sources, Charles Kirk in his commentary, and my astute colleague at Wall Street All Stars, Bob Marcin, have mentioned this method.  Neither endorses this approach, based upon the alignment of the stars, but both cite recent accuracy.  As Charles notes in his members only commentary, if Friday turns out to be a market top, everyone on trading desks will be talking about this.  [If it is not, there will soon be a new candidate.  Time for another article along the lines of the Hindenburg Omen.]
  • Federal tax receipts are soft.  Here is Dr. Ed's chart:

FIGURE78

 

The Ugly

Campaign advertising!  With the Illinois primary coming up on Tuesday, voter attention has turned from our last Governor (finally) starting his prison stretch with one more press conference, to the avalanche of attack ads interrupting the basketball.

There is a simple reason that political campaigns use these ads:  They work!  While voters claim to be high-minded, in fact these deceptive ads swing many opinions.

For an investment angle, you might compare this with advertising about Gold, a staple of certain talk shows, investment TV and radio, and commanding multiple-page spreads in the newspaper.

If so many people think they can get great investment ideas from ads on talk radio, what can we expect for their voting decisions?

 

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

This week continues two new measures for our table. The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon. (I know that I am behind schedule on this.  The message remains comforting.)

The second is the SuperIndex from PowerStocks research.  I am a big fan of Dwaine van Vuuren, whose excellent statistical work is giving us better insight into a wide range of recession forecasting methods.  The data point that I cite each week (the four-month recession outlook) is only one aspect of a comprehensive report.  The SuperIndex includes nine different methods, including the ECRI.  The analysis has a very strong, practical market application which has paid off richly for subscribers over the last few months.  How?   Mostly by putting the ECRI recession forecast into better perspective.

Spend a few minutes at their site and you will see the following:

  • A description of the SuperIndex components and methods.
  • A collection of research reports, including how to improve the ECRI method, using the Conference Board's LEI, and deciding how much recession warning you need.
  • A sample report.  This shows the richness of the weekly information, including differing time frames for recession warnings as well as an updated GDP forecast.

This is all driven by the most recent data from all of the indicators.

  Indicator snapshot 031812

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we are continuing our neutral vote, a position started last week, for the first time since December.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  For daily ETF commentary from Felix, you can sign up for Wall Street All-Stars, where I still have a few discounted memberships available.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

A Note on the Recession Outlook

We should note that the ECRI is still pounding the table on their recession forecast.  Even if this eventually proves to be correct, the timing was terrible for investors who took heed right away, missing a 25% gain.  I have been highlighting sources with better recession forecasts, including those that have better timing using the ECRI's own data.

My weekly review describes my conclusions.  It is not a place where I develop an argument, so let us save that for later.  Meanwhile, please read New Deal Democrat at The Bonddad Blog for a good analysis (calling BS) of the key issues.  The ECRI has not responded to the many critics, and they get very polite questioning in interviews.  It is past time for some real explaining.

The Week Ahead

This is not a big week for economic data other than housing.  I covered my thoughts about housing a month ago, and nothing has changed.  It is interesting that Calculated Risk thinks we might have a bottom.  This week's Barron's had the housing rebound story on the cover.

There are a raft of housing releases.  My focus will be building permits on Tuesday (a leading indicator) and new home sales on Friday.

Initial claims on Thursday is the most important weekly data series.  We also get the latest version of the Conference Board's leading indicators, which are expected to remain positive.

Fed Chair Bernanke gives a couple of college lectures.  Everyone will be watching for any policy hints, but don't hold your breath on that one.

There are some other Fed speeches.

To summarize, this is a week with little data, except for housing where nothing is likely to turn sentiment.  It is a week as quiet as they come, and right after options expiration.  Volatility has moved lower.

Trading Time Frame

Our trading accounts have been 100% invested since December. Felix caught the current rally quite well, buying in on December 19th. There are now only a few sectors in the buy range. The overall ratings have deteriorated.  This program has a three-week time horizon for initial purchases, but we run the model every day and change positions when indicated. Felix has been more confident than I have been on the trading time frame, and has stayed invested in the face of a lot of skepticism. This illustrates the importance of watching objective indicators instead of headlines.  Despite the weakening overall ratings, Felix kept us fully invested for trading accounts last week.

We have 28 sectors in the universe, so we can be fully invested if there are three strong sectors, even if the market overall is neutral or negative.

Investor Time Frame

Long-term investors should be aware of the rapid decline in the SLFSI.  Even for those of us who see many attractive stocks, it is important to pay attention to risk. In early October we reduced position sizes because of the elevated SLFSI. The index has now pulled back out of our "trigger range," and is declining further. This sort of decline has been a good time to buy stocks on past occasions. Worry is still high, but has now declined to a more comfortable level.

Even though stock prices are higher than in October, the risks are much lower. I am increasing position size for risk-adjusted accounts. (We cut back by about 30%). I am also looking more aggressively for positions in new accounts.

Our Dynamic Asset Allocation model has become much less conservative.  Gone are positions in bonds and gold.  DAA responds to the message of the market, cashing in on extended moves.  It is rather like what some call a "lazy portfolio" but better.

The Final Word on Safety

The most important question for any investor is the first one I ask of a prospective client:  Do you need to preserve wealth or to create wealth?

Left to their own devices, many people mistakenly go "all in" or "all out" instead of thinking about the right answer.

Once deciding on a level of safety, it is time to consider the risks, including those often ignored:

  • Gradual inflation, of 3-4%.  This will cut your purchasing power in half in twenty years.  Owning stocks that reflect price increases can help.
  • Weaker dollar.  This can also hurt your purchasing power, but can be offset by owning foreign stocks or US stocks with significant foreign exposure.
  • Rising energy prices.  If you own some energy stocks, you can actually benefit from this trend.

There are other examples, but my point is to open minds to a reasonable level of stock ownership.  This can be done through a very conservative plan of dividend stocks with enhanced yield or a more aggressive apporach.  The key is matching your personal needs to a plan.

The traditional concepts of safety are fine for those who are preserving wealth.  For the rest, this is an illusion.

 

The Quest for Yield (Part 6): Enhancing the Yield from Your Dividend Stocks

Since October I have been urging yield-oriented investors to combine the selection of good dividend stocks with covered calls. This system has been working very well, and readers have asked for more information about how to make these trades.

At the risk of giving away some information about our specific methods, I have decided to go into more detail.  I hope that readers find it helpful in meeting their risk/reward objectives.

Background

The combination of dividends and call premium will yield 10% returns +/- whatever happens to the stock.  If your time frame is a few years, and your stock picks are reasonable, you need only break even on the stocks to get a return that will solidly beat bonds and inflation.  On a total return basis you can aim to double your portfolio in eight years or so, without getting unduly aggressive.

This is a sweet spot for many investors.  You can do it, but it will take a little work.  I have already covered several key topics in prior articles in this series.  You will do best if you check out the past articles as well as this one.  If you want this to work, don't cut corners!

Picking Dividend Stocks

A great dividend stock must first be a great stock!

Too many investors just screen for high yield.  Many of these stocks trade as a function of the yield.  It is like buying a 100-year bond.  If you think that bond yields are going higher, these stock prices will go lower.  Here is the chart I ran in my original dividend article:

 

6a00d83451ddb269e2013488ab0ac6970c-450wi

If the only idea you got from this article (November, 2010) was buying Caterpillar (CAT), you were in at 80.

Other stocks at the top of a pure yield screen might include companies about to cut the dividend since their payout ratio cannot be sustained by the earnings.

When I am picking stocks I get ideas from many sources.  With ideas in mind, my most important screen is earnings-based, since that will eventually determine price.  I am a big fan of Chuck Carnevale's service, where you can get a long-term earnings history as well as many important metrics for stock valuation.  I do not take any long-term investment position without "talking to Chuck" via his site.  Even if you are not a subscriber (and you should be), Chuck graciously shares many of his best ideas and screens with a complete suite of charts.

So we now have a list of stocks with reasonable, well-supported dividends.

Covered Calls

In my original article on selling options against your stock positions, I did not focus on dividend stocks.  I did a careful description of stocks that fit the profile.  Some stocks that I liked but were not suitable for covered writes (Apple, then trading around 318, was not suitable because we did not want to cap our upside.  Other names were just fine, including my example of Noble Energy (NE) although I said the Microsoft was also a good candidate.

The article goes into some detail about sources and how to find the right call to sell.

Putting the Concepts Together

Last October I wrote about why investors should combine these two concepts to create a true total return, income portfolio.  The basic idea is that you should not fixate on stock price movement.  If you pick good stocks, collect dividends, and collect call premiums, you will achieve your target.  Do not get too frisky on your stock selection!

I had an interesting section in this article, which I called, "Do You Qualify?"

Here is the qualification test — hardly anyone can pass it!

You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.

This is what you would do with a bond portfolio.  You buy expecting to collect the coupon and the principal at maturity.  It is a simple test, yet a difficult one.  The bond investor does not worry about daily marks.

Psychologically, people cannot do this with stocks.

You should simply look at your statement and see if the combined flow from dividends and call sales are meeting the objective.

Implementation — A Look Under the Hood

I am going to share some "secrets" about how we are implementing this program, including some recent actual trades.

Here are a few specific ideas that were not part of the prior articles.  I am fussy about setting new positions.  I do not mind holding cash for a bit while looking for the right opportunity.  A good pick includes the following:

  • A stock that meets the dividend requirements described above.
  • A near-term option sale that would generate nearly 1% per month if the stock had no move.
  • A reasonable bid-ask spread on the option.  I have the advantage of being able to split the market in many cases, but you can try the same thing if your broker permits spread orders.
  • An option sale that will compensate you fully if the stock is called away at expiration.  This normally means that you get  an immediate payoff of 2% or so plus the call premium if the stock rallies.  You need a broker that does not soak you for an assignment on your short call.

I do not worry about losing stock positions in the current environment.  There are plenty of candidates.

Examples

To illustrate, here are some trades that we actually did last week for this program.

Bought Abbot on March 6th  (ABT) for 56.57 and sold the April 57.50 call for 57 cents.  If the stock had done nothing, we would have collected  a nice call premium as well as waiting for a dividend.  Given  the rally, we might just ring the cash register with a gain of 97 cents on the stock and 57 cents on the call premium — almost 3% in about six weeks.

Bought Conoco on March 5th (COP) for 77.41 and sold the April 80 call for 94 cents.  If the stock does nothing we again get a good premium.  If it is called away on April expiration we make $2.59 on the stock and $0.94 on the call, for a total of $3.53  — 5% in less than two months.

There are other similar trades.

This shows why we can afford to wait for good opportunities.  I go shopping on days where the market declines sharply, offering good stock prices and high call premiums.  My target is eight positions, but we sometimes have a smaller number when the market is not cooperating.

Conclusion

You can do this on your own if you have the right resources, the right broker, and watch the market closely.  You must also be patient.

When options expiration comes, you may have some new decisions about whether to "roll" your short calls or look for new opportunities.  I'll discuss this more in the next installment.

 [I still own the mentioned stocks — AAPL, NE, and CAT — as well as the specific option positions.