How to adapt your investment strategy: Do what the pros do, not what they say

There appears to be lots of cheer as the markets keep rising. But the 200-day moving average suggests this is a bear . . . in bull’s clothing. Understanding institutional trading techniques can keep you focused on your own best long-term investment strategy.

Here’s a cheery rhymed couplet from Ken Norquay’s investment book, Beyond the Bull, for anyone with an interest in the stock market. “Things are not as they appear: your champagne glass is full of beer.” Deception is particularly prevalent in the world of finance and investing.

Mr. Norquay, writing recently in The MoneyLetter about his favorite topic—behavioral finance and how it affects your investing strategy–continues:

When a pension fund or mutual fund manager wants to sell a large stock position, the last thing she wants is for “the Street” to find out that she’s selling. What intelligent investor would buy a given stock if he knew Goliath Fund Managers Inc. was selling? Intelligent investors would simply delay their buying program until Goliath Fund’s selling drove the price lower.

Instead, Goliath Fund would quietly and unobtrusively sell its position while pretending to remain optimistic and positive about it.

The fact is giant investment managers need other investors to buy the large investments they want to sell. That’s one reason why stockbrokers are always optimistic and positive. They need a plentiful supply of buyers to help stabilize the markets when the large investors need to sell. Deceit is an important part of the stock market.

What is happening versus what the big players say is happening

In my book, Beyond the Bull, I instruct small investors to have specific financial techniques to implement their investment strategy. A financial technique is an objective observation of something in the financial world that indicates what is actually happening—not what “they” are telling us. After all, what “they” are telling us is concocted to make sure there is someone willing to buy when “they” need to sell. In this article I will discuss a specific technique we can use to recognize when we are near the top of a stock market cycle.

Watch for a market top

I have recently been urging investors to look for a market top because the stock market has been going up for six years since hitting a low in March 2009. I have been encouraging investors to NOT “hold” through another 50 per cent drop in the stock market, as happened in 2001-2003 and again in 2007-2009.

Why not sell some of our stocks during the topping phase of the stock market and buy back during the bottoming phase? Let’s increase our long-term returns by avoiding loss. In this article, I will discuss a method investors can use to help gain confidence and good financial judgment to stay focused on their best long term investment strategy.

Using basic stock indices to take the market’s pulse

Most people follow the markets by following the stock market indices. Typically, we follow the S&P/TSX composite index in Canada, the S&P 500 composite index and Dow Jones Industrial Average in the U.S., and so forth.

When one of these registers a new high level, we assume most stocks are priced somewhere near their highest levels. And most of the time this assumption is true. But every once in a while massive institutional stealth selling enters the picture. In other words, deception creeps into the picture.

Sometimes big institutional portfolio managers want to become more defensive. Now, for example. They achieve this by quietly selling their less liquid investments and buying more liquid investments.

As a general rule, they sell smaller companies and buy larger ones. They sell their higher-risk, more volatile stocks and buy lower-risk, less volatile equities.

When we notice them doing this en masse, we should take it as a warning.

The challenge of following the market professionals

When professional market strategists are becoming more defensive in their investment strategy, we should become more defensive too. Our problem is: they don’t tell us they are becoming defensive; instead, they tell us everything is fine. They need us to remain positive and optimistic so that we will buy their stocks from them as they sell. They need to keep us in the game as they quietly move their portfolios into less risky positions.

To gauge the market’s true health, use the 200-day moving average

How can we detect what they are doing?

One method is to follow the percentage of stocks in an index currently trading above their 200-day moving averages.

For example, the S&P/TSX composite index is an average of Canada’s largest companies. The exact number included in the index changes over time, as companies are added to or removed from it, but the S&P/TSX composite index normally has about 250 companies.

If 188 of the 250 stocks on the index closed above their own 200-day moving average, the reading would be 75 per cent that day. If 218 of the 250 stocks closed above their own 200-day moving average, the reading would be 87 per cent.

There are about 200 trading days in a year. If a given stock is above its 200-day moving average, it is trading above its average for the past year. It is a “moving average” because each day the statisticians (or their software or cloud-based avatars) add one more day to their statistical total, and remove the one from 201 days ago. The average is always current for the last 200 trading days.

How portfolio managers behave at market tops . . .

At market tops, two significant things can happen. One is that portfolio managers sell their smaller companies and buy larger ones, as I discussed above. The other is that there can be excessive speculation in one or two large companies.

. . . shows up in the percentage of stocks trading above their 200-day moving average

Either way, what happens is revealed by this statistic: the percentage of stocks trading above their 200-day moving average. What happens is that fewer and fewer stocks remain in uptrends: more and more stocks drop below their 200-day moving averages, even as the stock market indices continue higher.

An extreme example of this occurred in the Canadian market in the year 2000. Many Canadian portfolio managers ploughed way too much money into a single company: Nortel Networks Corp.

Usually these moves to speculative over-concentration occur in a specific industry, not just one stock. We all recall the high-tech stock bubble of 2000 and the resource company bubble of 2008. These were examples of over-speculation in a few stocks at a market top.

However, it is a more common investment strategy technique to see the buying focused on large-cap defensive stocks.

In any case, both of these actions of large institutions can be followed using the percentage of stocks trading above their 200-day moving average.

What the NYSE’s 200-day moving average is telling us today

What are these numbers telling us about the U.S. stock market now?

In January 2013, the percentage of New York Stock Exchange stocks trading above their 200-day moving averages was 85 per cent and the NYSE composite index was at 9000. (This index includes all the stocks trading on the New York Stock Exchange, or NYSE.)

In February 2015, only 55 per cent of NYSE stocks are trading above their 200-day moving averages and the NYSE composite index is at 11,000. In other words, the U.S. stock market has gone up significantly while the number of stocks still in uptrend has gone down.

This divergence illustrates that large American portfolio managers have become more and more cautious in their investment strategy over the past two years. They are focusing their buying more and more on fewer and fewer stocks.

That divergence has been going on for more than two years: obviously this statistic is not a precise market timing indicator. Not even close! But it will help you develop judgment in the market because it helps you track the results of institutional money management in the U.S.A.

Reality vs. theory: Expect more zigs and zags

I have over-simplified this statistic so that we can see the pattern. In reality, neither the NYSE composite nor the percentage of stocks trading above their 200-day moving average progress in smooth straight lines.

All market statistics progress in zigs and zags. The two percentage figures I quoted above occurred at the tops of little upward zigs.

Although the tops of all the little up-zigs from January 2013 to February 2015 declined in a smooth line, the day-to-day and week-to-week figures fluctuated dramatically during that time.

The ‘kid brother’ effect: The Canadian market

Canadian investment managers think the same way as their U.S. counterparts, but operate in a less liquid, more volatile stock market. They usually take their market timing cues from observations of the U.S. market and adjust their investment strategy for Canada’s unique economy.

For example, right now Canada’s former investment darlings, the resource stocks, are in serious decline. If a Canadian portfolio manager had wanted to reduce risk, she would have sold her resource stocks and reinvested in the more liquid and less volatile bank stocks. We would have noticed resource stocks in downtrends and bank stocks in uptrends. And, of course, this is exactly what is happening.

Canadian investors should continue to be cautious and skeptical about the stock market. The market is near the top of the cycle and we should be thinking “sell,” not “buy.”

Are you preserving your capital? . . .

Think like a trader: preserve your capital and stay mindful of risk.

. . . Or looking to speculate?

But, as Yogi Berra is credited with saying: “It ain’t over till it’s over.” Some parts of the market are still in uptrends. For those who love stock market speculation, Canadian gold mining stocks still look promising.

Where the risk is now

Canadian oil stocks appear to have stopped going down for now and have had sharp down-to-up reversals. If energy stocks drop once more to near their previous lows, they could start to stabilize like the gold stocks have. But until that “test” occurs, energy stocks still represent more risk than gold mining stocks.

 

The MoneyLetter, MPL Communications Inc.
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