Investment strategy: be cautious, active and decisive

Ken Norquay is a Chartered Market Technician, author of the behavioural finance book Beyond the Bull and a regular contributor to The MoneyLetter. He is currently on a European reconnaissance tour and reports his latest observations and consequent strategic investment advice from Germany.

Sometimes the financial world seems like a war zone. In 2001, in the aftermath of the “dot-com” investment craze, the popular stock market averages dropped around 50% and our hapless mutual funds investments lay in ruins. In 2008-9, in the aftermath of the US funny money mortgage market and real estate bust, the stock market averages dropped in half again, laying waste investors’ hard-earned gains. In the same way that no one wants war, no one wants the stock market to drop in half. But wars, both military and financial, do happen.

The world’s financial fate is determined by forces much larger than any of us. We do not have the freedom to choose whether or not a financial war will occur.

Our choice lies in how we react. What is our personal financial strategy? Are we active investors, or passive? Are we decisive or indecisive? Are we cautious or bold?

I advise investors to be cautious, active and decisive

Decisive means we scan the financial world for specific information, and we use that information to increase or decrease the risk level in our investments. We increase risk by buying riskier securities (stocks or equity mutual funds) when the overall risk in the market is low and we reduce risk by selling our risky investments when overall stock market risk has become high.

Stock market risk changes over time. (In previous articles, we identified a period of high stock market risk last year. Our thesis is that the US stock market peaked in May 2015 and the Canadian market peaked in Sept 2014.)

Active means we have to actually sell our riskier investments. There will come a time when we actually should buy. “Holding” is a passive investment strategy. Buying and/or selling is active in the investment world; worrying, discussing, “riding it out” or “being patient” are all passive.

Cautious means we emphasize “not losing money” more than we emphasize “making money.” When I was the investment strategist for a small investment management firm, we used to advertise: “We make money by not losing.” We hoped: (1) to participate in up trending stock markets by investing in conservative stocks and (2) to be out of the markets when the trend was down.

My Strategic Investment Advice

In 2015 I warned that certain financial data indicated that the US stock market had entered the high risk part of its cycle. Financial war is at hand. I encouraged investors to sell stocks and reduce the overall risk of their portfolios.

In 2016’s articles, I will continue to monitor the financial world, looking for a time when it will be safe to invest in stocks again and I will discuss what happens in a typical bear market in stocks.

On reconnaissance in Europe

S&P500 corporate earnings are currently down 15% from their highest level recorded in 2015. According to my Counter-cyclical Model, about 6 months after the stock market peaks, the economy peaks. Corporate earnings are one indicator of economic strength/weakness. Because the US stock market peaked in May 2015, this earnings news confirms that the risk level in the stock market is higher than normal. (The Counter-cyclical Model describes the sequence of events that lead up to and follow stock market tops and bottoms. I have written about it in previous MoneyLetter issues.)

I am currently in Germany for the winter and will try to present financial data from a European point of view. In my investment book, Beyond the Bull, I encourage investors to develop judgment about the stock market by learning how others participate in the financial world. Europeans view the financial world differently from us. Their perspective is helpful in forming our best long term strategic investment plan.

For example, Europeans can invest internationally without incurring currency risk. When their 2011 debt crisis was rocking Europe’s financial world, investors in the troubled nations of Portugal, Italy, Ireland, Greece and Spain (the so-called PIIGS of Europe) could easily have switched their equity portfolios into German, Scandinavian or French investments and avoided their own much weaker stock markets.

They would not have undergone currency risk because German, Scandinavian and French markets are denominated in Euros. (If they had invested in Swiss or British markets, they would have incurred currency risk because those markets are denominated in Swiss Francs or British Pounds.)

However, if a Canadian investor, noticing the weakness in oil prices, had recognized the risk in the Canadian stock market, she could not have switched to U.S. stocks without incurring currency risk. (In this example, our investor would have benefitted significantly from such a move, because the Canadian Dollar was so weak vs. the U.S. Dollar and the US stock market was stronger than the Canadian.)

Europeans see the Canadian stock market as a good investment in times of inflation, particularly energy and raw materials inflation. Because so much of the Canadian economy is resource oriented, both our stock market and our currency tend to be in up trends when the prices of oil, base metals, precious metals, and agricultural commodities are in up trends.  But, how do Europeans see their own stock markets? And how do we see them? Let us examine the various European stock markets to see if we can find clues about how our own investments might fare in the next year of two.

Europe can be divided into two main sections: PIIGS and non-PIIGS. The difference is in debt levels. Portugal, Italy, Ireland, Greece and Spain were aggressive borrowers for years before the 2011 Euro-debt crisis.

Other European nations were not so aggressive. (Note: the small nation of Iceland is the exception – it developed its own banking crisis based on super-aggressive bank lending policies.) As a result, the economies of PIIGS heated up, then crashed and burned as the world came to realize they were unable to repay their loans.

Now those economies are cooling off as they struggle with austere measures dedicated to reducing their debt levels. This economic weakness has manifested in stock market weakness.

North American markets peaked in autumn 2014 (Canada) and spring 2015 (USA) having both exceeded their previous high levels of 2008 (Canada) and 2007 (USA). The larger markets of Europe performed similarly, but slightly less robustly.

Euro-Market reviews

In autumn 2014, the German market had risen from its 2009 low to approximately the same level as its previous 2007 high. There was a slight decline and then it rose to approximately that same level in spring 2015. The German DAX is in a down trend now.

In spring 2015, the French market had risen to a level slightly below its previous 2008 high. It is in a down trend now.

In spring 2015, the British stock market had risen to a level slightly higher than its previous 2008 high. It, too, is in a down trend now.

What about the stock markets associated with the PIIGS? First of all, Ireland and Portugal do not have meaningful stock market indices. The high water marks for Spanish and Italian markets occurred in 2008 and they never did re-attain those former levels. Greece was the hardest hit: their stock market is only a fraction of what it was at the 2008 high. All are in down trends.

These observations confirm that European stock markets are in sync with North American, but are underperforming. European stock market investors face similar problems to North Americans. European mutual funds are not an alternative for Canadian investors.

Some analysts feel the 2-year crash in oil prices should benefit the European nations (except for Britain, which is a significant oil producer), but that economic benefit has not affected their stock markets. Lower oil prices do not seem to have helped Europe’s stock markets nearly as much as they have helped Europe’s consumers. All Europe’s stock markets are in down trends, in harmony with North American stock markets.

Caveat emptor

Our economic early warning radar screen has picked up two interesting blips. First of all, the price of gold has risen dramatically so far in 2016. It is possible that the price of gold is changing from a long term down trend to an up trend. Secondly, long term US interest rates (as measured by the price of twenty year government bonds) have dropped sharply so far in 2016. If this strength in US bond prices continues, it will weaken our case that US stocks have peaked. The current red light ‘sell’ signal would change to a yellow caution light.