Strategic investing and the unknowable

“…there are known knowns; …there are known unknowns; …there are also unknown unknowns.”–Donald Rumsfeld.  “Don’t pretend to know the unknowable.”–Ken Norquay.

Behavioural finance strategist Ken Norquay is a frequent contributor to The MoneyLetter and author of the book Beyond the Bull which discusses the impact of your personality on your long term investment strategy. His recent travels gave him occasion to reflect on financial trends and stock market forecasts. He writes:
 
I recently returned from a trip to Europe where I enjoyed the experience of their diverse cultures and their strong sense of history. I met an American woman who is following the US primary political campaigns with great enthusiasm: she supports her candidate by sending him cheques. She was deadly serious and single minded. She followed all the opinion polls, was suitably outraged by the opposing candidate’s opinions and expressed great confidence that her man would win out in the end.

“Aye, there’s the rub,” I thought: confidence. Unlike the political arena, in the unforgiving world of the stock market, it is an error to have too much confidence in the unknown. And the future is always unknown.

What is the correct way for us to operate in a world of so many unknowns? In the investment world, the standard answer to this serious question is almost comical: “We pretend to know.” In my stock market book, Beyond the Bull, I openly mock the securities industry’s reliance on financial research and economic forecasting.

I compare financial forecasting to the art of fortune telling. Their premise is that the future is predictable, and that we should invest in securities that would benefit from the future they are forecasting. This makes sense only to large institutional money managers, where liquidity is their main problem. They own such large amounts of a given security that their buying or selling dramatically affects the price; they are stuck with that investment “come hell or high water”.

So, if some economic genius can predict whether it’s going to be “hell” or it’s going to be “high water”, that forecast is considered useful. But for ordinary investors (those with $10 million or less invested in the stock market) this is folly. A $10 million portfolio of reasonably liquid stocks can be sold or bought in the twinkling of an eye. Forecasts are a distraction for the small investor. Forecasts give us confidence when we should be cautious. What we need is an action plan.

Follow financial trends – not forecasts

Instead of aligning our investments with some financial forecast, we should align with current financial trends. If the stock market is moving up, we want to invest in the stock market. If the market is moving down, we do not. The strategic investing trick is recognizing the current trend, not forecasting the future.

Our premise is that financial trends go until they stop. (Ouch! That’s so obvious, it’s painful!) Our research is dedicated to identifying when a given financial trend stops and reverses. Then it becomes relatively easy to change our portfolio to match those financial trends.

The last lines of my book are: “At no time do we dream about knowing the future. At no time do we bet on the future. At no time do we pretend to know the unknowable.”

Let’s review our current view and determine if the financial trends are still intact.

The US stock market: the top occurred in May 2015 and was followed by two sharp declines and two partial recoveries. The second sharp decline ended in a “double bottom” on Jan. 20 and Feb. 11, 2016. The market is in the “partial recovery” now. Although the two heart-stopping declines attracted the attention of the financial press, the current mood of stock market investors is complacency.

Australians would say: “No worries, Mate!” The Canadian stock market top occurred in September 2014, 19 months ago. Stocks are in a down trend.

US 20-yr + interest rates bottomed at the end of January 2015, fourteen months ago, following the gradual reduction of the American Federal Reserve Board’s super aggressive Quantitative Easing stimulus programs. This “down-to-up” interest rate trend reversal was confirmed by the Fed’s tiny increase in short term rates late last year.

Interest rates are in an up trend, albeit a shallow up trend so far. Canadian long term interest rates bottomed on exactly the same day, but the Bank of Canada has not moved short term rates because our economy is so weak. Low energy prices are having a serious impact on the Canadian economy.

There is a possibility that the trend of oil prices has finally stopped going down. Following the Feb 11, 2016 low of $27.30 US per barrel (Sweet Light Crude Oil Index), the price recovered sharply to $41.80 on March 21.

If the price holds between those two levels for the remainder of this year, it might help the oil dependent economies of the world find some stability and confidence in their long term energy business plans. In the meantime, those once-glorious plans for tar sands, shale oil and pipelines have turned into pipe dreams, and American environmentalist politicians are celebrating how they stopped them.

Until we have more evidence of energy price stability, oil stocks remain speculative; for disciplined traders only.

Gold has completed its down trend, having peaked in Sept. 2011 at $1,920 US an ounce. It finally stopped going down in Dec. 2015 to just under $1,050. The price recovered sharply to $1,287 in March. After such a sharp recovery, we should look for a cool-down period, but speculators take note: many Canadian gold mining stocks are in up trends.

Make the Yankee dollar work for you

The US Dollar, as measured against the basket of non-US currencies, has stabilized after a steep one-year up trend, a 26% increase from May 2014 to May 2015. Since then, it has stabilized in a 7% range between 93 and 100. Currently it is trendless, neither in an up trend or a down trend.

The Canadian Dollar vs. the US Dollar: The Canadian Dollar downtrend began five years ago, in May 2011 at about $1.04 CDN per US$. The low so far was just over $0.67 in January of 2016. The Loony’s price is strongly linked to the price of oil, as are so many other petro-currencies.

Based on these financial trends, we can conclude:

1. Our portfolios should have very low exposure to the stock market.

2. Our portfolios should have low exposure to the bond market.

3. Speculators trading Canadian oil stocks will enjoy the action.

4. Speculators trading both longer term and short term investment strategies will enjoy the action in Canadian gold mining stocks.

5. Canadian investors can profit from increased exposure to US Dollar denominated investments.

For investors interested in speculation, here are four Canadian gold mining stocks in up trends, and the time and price at the beginning of this up trend.

■ Detour Gold (TSX─DGC); Dec 2013 – $3.55; April 8, 2016 – $23.23

■ Nova Gold (TSX─NG); Dec 2013 – $1.99; April 8, 2016 – $7.55

■ Semafo (TSX─SMF); July 2013 – $1.40; April 8, 2016 – $4.71

■ Kirkland Lake Gold (TSX─KGI); Dec 2013 – $2.24; April 8, 2016 – $8.60

Please notice that the current prices of these gold stocks are significantly higher than they were at the beginning of their up trends two or three years ago. Even though the price of gold had been declining during the past few years, the price of these volatile stocks has been rising.

Investors who are less risk oriented should examine precious metals sector mutual funds or ETFs.

Because the up trend in the price of gold is so new, most financial advisers still consider precious metals investments to be riskier than they actually are. Most will advise their clients against investing “too much” in precious metals.

Similarly, because the down trend of the stock market is still in its early stages, most investment advisors still consider stocks to be safer than they really are. Most will warn their clients not to be caught without a full portfolio of stocks at all times. This is the irony of the investment world.

The majority is usually bullish at the top and bearish at the bottom. The Theory of Contrary Opinion rules the investment world.

In the political world, majority rules. My politically enthusiastic American friend might have been expressing “hope” that her candidate would win, and calling it “confidence”. Her undying hope that Bernie will win has her sending cheque after cheque to his campaign headquarters. She hopes he will win. Right now that hope is costing her dearly.

In the stock market, hope is deadly. Some refer to a down trending stock market as “the slope of hope”. Investors hang on and hang on, hoping for a recovery. This is why it is important to always stay cautious in the investment world. Confidence is always over confidence. Doubt is healthy. Skepticism is healthy. Hope can cost you dearly.