'Buy - Don't Hold': When to Get In and Out of Markets

by: Larry MacDonald

Curiosity led me to a recently published book, Buy – Don’t Hold: Investing with ETFs Using Relative Strength to Increase Returns with Less Risk (2010). The author, Leslie Masonson, is president of Cash Management Resources and a stock-market investor for close to 50 years.Buy--DON

Masonson acknowledges the findings of a prominent study that the U.S. stock market returned an average 9.6% annually from 1926 to 2008. “But that provides no clue as to what the next few years or decades will bring,” he argues.

In fact, many 20-year periods have had very low returns. A study by investment author John Mauldin looked at 88 such past periods and found half of them generated compound annual returns less than 4%. After inflation, most recorded negative real returns.

Investors therefore need an approach that gets their portfolio out of stocks when a bear market arrives and back into stocks when a bull market comes along. His book sets out such an approach.

The first of two steps is to determine if the market is in an uptrend or downtrend. Mr. Masonson offers eight technical indicators for this task. One, for example, is the percentage of stocks above their 50-day moving average.

Masonson’s blog at his website www.buydonthold.com reports weekly on the signals from his indicators. On April 27, they gave a sell signal (just before the meltdown in May). On July 15, they gave a buy signal.

Once indicators are signaling an uptrend, the second step is to select a basket of exchange-traded funds (ETFs) on the basis of relative strength. By relative strength is meant ETFs with the largest price gains over the previous six months.

Some investors may simply rank ETFs from highest to lowest relative strength and buy the top 10 to 15. Certain ETFs, such as inverse or low-volume ETFs, might be excluded. Two websites for ranking U.S. ETFs are www.etfscreen.com and www.etftable.com.

Mentioned in the book is the work of Robert W. Colby. His website publishes a list every week of the 10 ETFs with the highest relative strength over the past 6 months. According to Mr. Colby’s simulations, a portfolio based on his top-10 ETFs is up over 100% since August, 2004, compared to a gain in the S&P 500 of about 2%.

To ensure a diversified portfolio, some investors may want to stratify the ETF population and select ETFs from the different strata. Five strata are defined in the book: fixed-income, industry sectors, international, style and specialty (gold, agriculture, etc.). The more conservative an investor, the more money they should allocate to the less volatile strata, particularly fixed-income securities.

As Mr. Masonson notes, one issue with this approach is the transaction costs from frequent buying and selling. A second issue is higher capital-gains taxes in taxable accounts. A third is the time required. A fourth is the efficient markets view, which asserts technical analysis may not be effective.