A financial behaviourist’s strategic investment advice

A rational market strategy: Participate in uptrends, reduce exposure to downtrends. Right now, the signals are saying: ‘Sell’. They’re not as simple as ‘Buy Low; Sell High’, but they are particularly clear signals according to Ken Norquay, author of the behavioural finance book Beyond the Bull  which discusses the impact of your personality on your long-term investments.

When I was a rookie stock broker in the mid-1970s, I asked my manager about the bull market: “How long does a bull market last, George?” He answered: “Until it stops.”

Years later I discovered how wise his words were. Financial trends go until they stop. Rather than forecast how long a given financial trend will last, the analyst should look for the signs of a trend reversal.

With this wisdom in mind, let us examine the financial trends currently in effect, on the assumption that these trends will continue in 2016 until we see them change.

Stock market trends

Most modern investors have serious money invested in the stock market. Following a nail-biting downtrend from spring 2008 (Canada) and autumn 2007 (United States), stock markets reversed into beautiful long-term uptrends starting in March 2009.

Currently, the highest level for the Toronto Stock Exchange’s uptrend occurred in September 2014 when the TSX Composite Index hit 15,685. The S&P 500 Composite Index hit its high in May 2015.

Both of these markets are currently in the early stages of downtrends. In a year or two, when the downtrends are closer to the end, we will discuss what to look for when it’s time to reinvest in stocks. However, now, in January 2016 (and for the past seven months), it’s time to sell.

Interest rate trends

To monitor the trend of interest rates, we have to understand this crucial principle: long-term interest rates (reflected by the price of long-term bonds) lead short-term interest rates (reflected by the price of short-term treasury bills). Central governments manipulate short-term interest rates as a way of heating up or cooling off the economy.

Right now, the Canadian economy is struggling and our central bank is valiantly keeping short-term interest rates low in hopes of stimulating our economy. Good for them. We all hope their strategy works. But the long-term bond market tells a different story.

Both Canadian and U.S. bond markets peaked at the end of January 2015. (Bond prices and bond yields have an inverse relationship: when bond prices rise, yields fall, and vice versa.) Long-term interest rates are in the early stages of an uptrend.

On December 16, 2015, the U.S. Federal Reserve Board increased its overnight lending rate from 0.25 per cent to 0.5 per cent. This was a mini-confirmation of the up trend in U.S. interest rates that had begun almost a year before.

It’s important to remember that long-term interest rates are the lead indicator—the Federal Reserve’s (short-term) interest rates are the lag indicator. Without this understanding, you cannot understand how interest rates influence your stock market investments. First long-term interest rates reverse; then short-term.

The down-to-up reversal of long-term interest rates is a lead indicator for the stock market top. If you follow only short-term interest rates, you could miss the stock market top. For example, in 2015, long-term U.S. interest rates bottomed at the end of January. The U.S. stock market topped in May. Months later, in December, the Fed raised short-term interest rates.

Market trend of Canadian dollar

The loonie hit a new low versus the U.S. dollar just a few days ago. It’s in a clear downtrend.

Market trend of U.S. dollar

The trend of the U.S. dollar, measured against a standardized basket of non-U.S. currencies is not so clear. Following an uptrend that began in summer 2014, the U.S. Dollar Index rose to 100.39 in March 2015; traded sideways in a six per cent or seven per cent range until its second high of 100.51 last month (December 2015). It is unclear whether the uptrend that began in 2014 is still intact or is reversing.

Market trend of gold

The price of gold peaked in September 2011 at US$1,921 per ounce and touched a new low last month at $1,046: downtrend.

Market trend of energy prices

The price of crude oil in U.S. dollars also recently touched a new low and the downtrend was confirmed by a concurrent new low in the price of natural gas.

Downtrends versus uptrends—what to do

Investors should reduce exposure to downtrends and participate in uptrends. The U.S. and Canadian stock markets, the U.S. and Canadian bond markets, and the Canadian dollar are examples of downtrends. For example, if a conservative Canadian investor had cash in a U.S. dollar bank account on January 1, 2015, (paying zero per cent interest), she would have earned about 8.5 per cent last year (in Canadian dollars) because U.S. dollar rose versus the loonie. If she had purchased Horizons US Dollar Currency Exchange-Traded Fund (TSX─DLR.U), she would have made 18.9 per cent in the same one year.

The importance of an investment strategy

In the 21st century, there have been good years and bad years for stock market investing.

Canadian stock market

Gain Years: 2000, 2003, 2004, 2005, 2006, 2007, 2009, 2010, 2011, 2012, 2013, 2014
Loss Years:  2001, 2002, 2008, 2015
Neutral Years: None

American stock market

Gain Years: 2003, 2004, 2005, 2006, 2007, 2009, 2010, 2012, 2013, 2014
Loss Years:  2000, 2001, 2002, 2008
Neutral Years: 2011, 2015

Perfect strategy: Buy low; Sell high

In a world where investment trends are 100 per cent predictable, it would have been wonderful to be in the market in the good years and out of the market in the bad years. Unfortunately, ordinary investors have to live with the reality of unpredictability. That’s why we need an investment strategy. How will we make decisions in an unpredictable world? In an uncertain world, we will certainly make mistakes. What kind of mistakes? As 2016 begins, let us resolve to review our investment strategy, asking the following questions:

1. Is our investment strategy active or passive? If our strategy is passive, (for example, “buy and hold for the long term”), is it really a strategy?

2. Can we actually implement our strategy, or is it just an idealized notion that would be “nice” if we could do it? (For example, “Buy low, sell high.”)

3. Do we have rules . . . or are we just making decisions as we go along?

4. What data do we need to make decisions? Is the information reliable? available? timely?

5. What are the consequences of error? How will we handle our losses?

In my stock market book, Beyond the Bull, I outline a simple strategy for assessing stock market risk, and buying or selling your stock portfolio as risk changes. It’s a mechanical model that requires the investor to sell all their stocks when the S&P500 declines 7.2 per cent from a new high, and to buy when it increases 8.4 per cent from a new low.

The Reversal Model had been back-tested by Ned Davis Research, a U.S.-based institutional analyst and investment dealer. In 2008, when I published the book, only about half of the trades generated by this model were profitable. The model makes several neutral trades, resulting in small profits or small losses.

The real value of the Reversal Model is that it is always invested for big uptrends and always out of the market for big downtrends. In sideways markets, it makes a little sometimes and loses a little at other times. Yet the long-term rate of return of the model is about 50 per cent more than a buy-and-hold approach. The Reversal Model was in buy mode until recently, having ‘bought’ in October, after the sharp drop last summer. On January 7, it switched to ‘sell’.

Reason versus greed and fear

I am sometimes criticized for making investors nervous or fearful. Please do not be afraid. I am presenting a rational sequence of ideas that relate to the trend of various investments. The strategy is to invest only in uptrends. Do not invest in downtrends. It’s strategy. Those who do not have a well-thought-out strategy are the ones who will feel fear when the stock market finally reaches the bottom. Investors lose only when they fail to sell their down trending investments. It’s not about fear—it’s about selling.

In 2016, expect the financial trends we’ve outlined to continue. Down trending stock markets always end with high volatility. The escalating conflict in the Middle East, consistently weak Western economies, and the volatile action of the Chinese stock market, should provide plenty of financial drama this year.

Even speculators need an exit strategy

Conservative investors should err on the side of safety. Speculators should investigate exchange-traded funds (ETFs) or put options that take advantage of the market trends outlined in this article. Examples are Horizons US Dollar Currency ETF (TSX─DLR.U) on the TSX to take advantage of the weak Canadian dollar and ProShares UltraShort S&P500 ETF (NYSEARCA─SDS) in New York to take advantage of a declining U.S. stock market. Remember, it is doubly important for speculators to create solid entry and exit strategies.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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