How to spot and act on trend reversals in volatile markets

“If Winter comes, can Spring be far behind?” When Shelley wrote his famous poem “Ode to the West Wind”, he was looking forward to the gentler times of spring. Instead, let’s look back to the gentler times of last spring’s financial world, says Ken Norquay, a Hamilton, Ontario-based Chartered Market Technician (CMT) and author of Beyond the Bull, a book about behavioral finance and the impact of your personality on your long-term investments.

The U.S. dollar had been stable for getting on three years. The price of crude oil had been trading within a narrow range for four. American stock markets had been rising slowly and fairly steadily for about three years. Previous problems in the economy and banking system seemed to have been solved. Spring of 2014 was a time of financial tranquility.

So, what went wrong between last spring and now? For one thing, the U.S. dollar bounced up almost 10 per cent from May to October 2014. Then the price of crude oil went down more than 25 per cent from June to October.

As well, as fall started, American blue-chip stocks dropped almost 10 per cent in five weeks, then regained most of that loss in the next three weeks. In those same five weeks the S&P/TSX Composite Index dropped 18 per cent before recovering some ground in late October and early November.

Navigating choppy markets

What does all this volatility mean? And how should we react to it?

Volatility usually occurs at the end of a trend, or halfway along the trend. It is a sign of either a trend reversal or a trend confirmation. In previous articles I have been drawing investors’ attention to the length of the current stock market “up trend,” which has lasted over five and a half years.

The recent breath-taking volatility of the U.S. and Canadian stock markets is almost certainly a sign of trend reversal. It’s a time to remember. To remember what happened following the stock market trend reversals in the years 2000 and 2007-2008.

Recent trend-reversal lessons

During those pullbacks—in 2000 and 2007-2008—stock markets dropped in half, suggesting the equity portion of your RRSP also likely dropped roughly 50 per cent. After such a long stretch without a market correction (i.e., a pullback of 10 per cent or more), last month’s market volatility was a reminder that trend reversals do happen—that they are neither a purely academic concept nor a phenomenon that existed only in the past.

Market warnings: 2000, 2007-2008, 2014

The American stock market gave two such warnings in 2007: one in the spring and one in the summer. The final peak occurred in November 2007.

The two S&P/TSX warnings came in summer 2007 and the winter 2007-2008. The peak eventually occurred in spring 2008.

Back in spring of the year 2000, the S&P 500 Composite Index dropped 14 per cent in one month before the final peak later that year. At the same time, the Canadian market dropped 17 per cent, heralding the famous “Nortel Top” that would come later that year.

In short, in 2007-2008 stock market tops gave us two volatility warnings of the impending market peak; the 2000 top gave us one. The 2014-2015 top has given us one warning so far.

Now what should we do?

Our first choice is to do something or to do nothing.

Most modern investment advisers and financial planners suggest that investors do nothing. We are all familiar with the philosophy of “buy and hold” for the long-term.

“Hold” is another word for “do nothing.” This is good advice when the market goes up and bad advice when it goes down.

My advice is to remember how you felt after the stock market dropped in half between the high of 2000 and the lows of both 2002 and 2003, and then again in 2008-2009. Please remember. If you can’t remember, please go on the Internet and find stock market index charts that will remind you what happened in those years.

Or take out the monthly statements of your investments during those times and review what happened. Most investors who do this will realize they have to do something. Doing nothing is folly.

We need to change our investment plan to take risk into account: the risk that our equity portfolios could drop by 50 per cent as they have in the past. Our investment plans must include a plan to sell.

Six features of a good investment plan

In my investment book Beyond the Bull, I outline six features that a good investment plan should have. Let’s review them now.

1. Intentionality. Our action plan must be a deliberate attempt to make money in some specific way. Above all, it must intentionally avoid losing money. And it must take into account the fact that luck is an important part of stock market investing. How will we take advantage of good luck and avoid serious loss when we have bad luck?

2. Intellectually Sound. Are our assumptions accurate? Will our strategy work? Or are we just betting on some Pollyanna securities salesman’s pipe dream? How would our strategy have worked in the past?

3. Emotionally Doable. Can our normal human emotions handle our action plan? Or will we feel so good about our successes and so bad about our losses that we won’t be able to continue using our plan objectively? Will our action plan produce excessive stress in our life?

4. The Right Feel. Will our action-oriented investment plan stir up fear or greed? If so, our plan is doomed from the start. Fear makes us sell when we should be buying. Greed makes us buy or hold when we should be selling. Greed draws us in and makes us overconfident.

5. Mechanical Excellence. Can we actually do what our plan calls for? All good investment plans call for us to observe something in the economic world and react to it. Can we actually find the information we need to make our investment decisions? How reliable are our sources? Do we have backup? Will we receive the information on time? Can we act on time?

6. Customized Plans. We need to know our own personalities. If we are indecisive or poorly disciplined, our plan should give clear “buy” and “sell” signals. If we are natural leaders and highly confident, we may have trouble following a plan at all. Our investment action plan should take into account our personality. A plan that is good for the goose is not necessarily good for the gander.

A simple plan for U.S. blue chips

Here is an example of a simple plan for investors who want to own blue-chip American stocks. It involves buying and selling units of the broad-based American Exchange-Traded Fund, S&P 500 SPDR E.T.F. (NYSE-SPY). Sell when S&P 500 reverses 7.2 per cent from up to down. Buy when the S&P 500 reverses by 8.4 per cent from down to up.

This plan ensures that you will be invested in every important up trend and on the sidelines in every important downtrend. And when the market fluctuates dramatically, as it did last month, there will be transactions that will result in small losses and small gains.

Over the long term, the net result of all those transactions is a significant gain over the do-nothing plan of buy and hold.

Make a ‘do-nothing plan’ do something

Even a do-nothing plan can be enhanced by doing just a little bit. For example, perhaps your do-nothing plan is to buy a portfolio of well managed mutual funds and hold them for the long-term. Each year you invest half of your RRSP deposit in this plan.

If you just make one small adjustment to this no-action plan, you can meaningfully increase your long-term rate of return. If you had bought on the first banking day after Halloween, instead of during RRSP season, you would have taken advantage of seasonality statistics. Your long-term rate of return would have been higher by one per cent or two per cent annually, depending on when you started.

As you look over these two simple plans, refer back to the second of the “Six Features of a Good Investment Plan”: Intellectually Sound. Check out my statistics. Just keep in mind that they are based on the American stock market—not the Canadian, not bond markets or commodities—and are in U.S. dollars.

Volatility & emotion

Increased volatility and increased investor emotions go hand in hand. The third of the “Six Features of a Good Investment Plan” tells us our plan should be emotionally doable. As volatility continues to rise, investor emotions will continue to rise. The easy days are over.

The actual creation of a suitable active investment plan is beyond the scope of this article. Most investors will need help. But where can we turn for help in an investment industry dominated by “buy and hold” advisors? This is the dilemma of the average investor.

Using the S&P 500 reversal model above, investors would have sold and bought back blue-chip American stocks, incurring a small loss. Depending on how they use American statistics for Canadian investing, they might have sold their Canadian stocks and not yet bought them back.

 

The MoneyLetter, MPL Communications Inc.
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