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Strategic investing: market outlook calls for action

Six years ago was the right time for aggressive investing. The time for extreme caution is coming soon. That’s the market outlook from Ken Norquay, CMT and author of the book Beyond the Bull, which discusses behavioural finance and the impact of your personality on your long term strategic investment plan.

I am inspired by the words of Malcolm Muggeridge, 20th century author and philosopher: “Few men of action have been able to make a graceful exit at the appropriate time.” Nowhere is this truer than in today’s stock market. The difficulty with Muggeridge’s wisdom lies in two areas: 

1) “Men of action,” and
2) “The appropriate time.”
Most investors are not men—or women—of action and the investment industry is not geared toward advising investors about the appropriate time to exit. I will try to help you judge the appropriate time in this article. But becoming a man or woman of action is up to you.

We all recognize that, in the stock market, there is an appropriate time to exit. So far in the 21st century, the stock market has dropped in half, twice: once in 2000–2003 and once in 2007–2009. Investors easily recognize the value in selling before the market averages drop by 50 per cent. Everyone understands how much better our long-term rates of return would be if we did not have to double our money just to break even.

Lots of motivation, but it’s a question of timing

The motivation to act, (i.e., knowing the value of an appropriate exit) is not our problem. Correct timing is the problem. Investors worry that, if they exit from their stock portfolio, the market will keep right on going up and they will miss out. In other words, greed blocks them from acting.

And if they do not exit and the market does start to go down, investors worry that if they sell, the market will bounce right back up and they’ll be left looking foolish. Fear holds them back.

Prepare a stock market exit and entry strategy

For these reasons, I recommend that investors have a pre-planned exit and entry investment strategy for their stock portfolios. A proper strategic investment plan involves the following: 1) Observing the financial world objectively; 2) Looking for specific reasons to either buy more stocks or sell some (or all) of your shares; 3) Acting when you see those reasons. For investors who have such a plan, the time to act on your exit strategy is near-by.

The counter-cyclical model

In my book, Beyond the Bull, I describe a financial model for a stock market outlook that will help us make exit and entry timing decisions. The counter-cyclical model shows the lead-lag relationship between the stock market, interest rates and the business cycle. At tops, the bond market peaks first, then the stock market, then the economy. Saying “the bond market peaks” is another way of saying “interest rates bottom.” Following a bond market peak, after a lag period of six months or so, the stock market peaks. In general terms, six months or so after the bond market peaks, we should reduce risk in our portfolios by acting on our exit strategy; we should sell our stocks.

The counter-cyclical model also calls for the economy to start to contract about six months after the stock market peaks.

Applying the model

Important question: When will the bond market outlook call for a peak?

Answer: It already has. The U.S. long-term Treasury bond market reached its high on January 30 of this year. The Canadian bond market topped just after that, in the first week of February. The clock is ticking. Unless long-term bond prices start to rise again, the stock market outlook calls for a peak about six months later: in July or August.

Most investors and their advisors do not understand how the interest rate cycles work. We have all observed that there are long periods when interest rates move up or down. Many of us recall those days when five-year mortgage rates were over 20 per cent: now they are under three per cent! Interest rates have been in a down trend since 1980.

Long-term interest rates lead short-term interest rates

The financial media reports regularly on changes in the market outlook for short-term interest rates. Investors can easily keep abreast of the rate at which the central banks loan money to the commercial banks. What most investors have not observed is that long-term interest rates lead short-term interest rates; i.e. 20-year bond interest rates reverse before 30-day Treasury bill rates.

The financial press does not focus on the market outlook for long-term interest rates. Right now the Bank of Canada’s overnight rate is 0.75 per cent. It had been one per cent since the financial crisis of 2008–2009. The Bank of Canada lowered the rate in January because it sensed a weakening in Canada’s economy due to the collapse of oil prices. The Bank of Canada was right: the Canadian economy shrunk a bit in the first quarter of this year.

If the Bank of Canada’s rate dropped from one per cent to 0.75 per cent, why am I saying interest rates have reversed from down to up in January/February? And why am I using that indicator to forecast a peak in the stock market this summer? It appears that the Bank of Canada disagrees with my position.

Long-term bond yields are rising

My reasoning comes from two sources: 1) the observation that both U.S. and Canadian long-term bond prices have fallen—about 16 per cent and eight per cent, respectively—since early February; and 2) the counter-cyclical model is signaling a more dangerous situation than normal.

Worrying signals

How about that second point: that the counter-cyclical model is indicating conditions are more dangerous than normal?

Normally, the long-term bond market peaks first; then the stock market peaks about six months later; then the economy peaks in about six more months. This is the normal peaking sequence.

This time could be different. In the first quarter of 2015, the economies of both Canada and the United States shrunk slightly. If this weakness is the first sign of longer-term economic weakness, 2015 will be the first time since the 1930s that the normal peaking sequence has been broken. If Canada or the U.S.’s economies do shrink more in the second quarter of 2015, the peaking sequence this time would be: bond market peaks, then economy peaks, then stock market peaks. When this happened in the late 1920s and 1930s, it was very bad for the stock market.

A summer ‘sell’ signal?

I am not saying further economic weakness will happen. Canadian and U.S. governments and central banks are taking action to prevent further weakness. We all hope second quarter economic figures will show strength and the counter-cyclical model’s market outlook of “more dangerous than normal” status will pass.

But the counter-cyclical model’s normal sell signal for Canadian and U.S. stocks still stands. However, if long-term bond prices regain at least the amounts they lost (16 per cent in the U.S. and eight per cent in Canada), we would know that the bond market had not really peaked in January/February 2015. The summer sell signal for the stock market would be nullified.

Fear, greed and free-market economies

For those of you who love to follow the outlook for financial markets, this is clear. You understand the pushes and pulls of cause and effect in the world of money. But imagine how this must look to those who invest in the stock market, but are not interested in things economic. Investors like that want clear and simple instructions. But the financial world is not clear and simple: it’s complex. No one wants a recession or depression. No one wants the stock market to go down. Everyone wants prosperity. But that’s not how free-market economies work. Repetitive cycles of fear and greed continually win out over the wishes of the well meaning and the rational.

Time for cautious investing

The crash in oil prices has already brought the Canadian economy to its knees. If interest rates rise, debt-ridden Canadians will receive another economic jolt. There are serious risk factors built into Canada’s economy right now. The time for bold investing occurred six years ago in the economic crisis of 2009. Now is the time for cautious investing. The time for extreme caution is coming soon.

Get ready to sell

I advise conservative investors to review your pre-planned entry and exit strategies now. Prepare to exit this summer. Once you have reaped the harvest of this six-year bull market, you’ll have plenty of cash reserves to re-enter the market when the time comes. Sometimes the decisive action involved in our stock market exit strategy can threaten our confidence. It seems counter-intuitive to sell at tops. I suggest a review of your entry strategy. This review will give you added confidence in your decision to exit.

For the aggressive: buy ‘puts’ or short-sell stocks

Those of you who enjoy the action of the markets should increase your knowledge of selling short and buying put options. (“Put options” provide a means of profiting from a falling market.) Stock market down trends have always been steeper/faster than up trends. If you develop skills in short selling or put-option speculation, the speculative action will be dramatic when the bear market sets in.

Two areas especially at risk

Those who have been speculating in Canadian junior gold mining stocks or energy stocks should unwind your positions in the next few weeks. It’s time to stop expecting stocks to go higher.

 

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