Just Normal To-And-Fro

by: Jason Kelly

The following is from this year's Note 29 of The Kelly Letter, which went out to subscribers last Sunday morning.

The simple allocation in our three tiers works well through various market environments because we own asset classes that do not correlate. This is the only distinction that matters. Diversification among different types of stocks, for example, is not useful when the market crashes because they all go down together. This is especially true in modern markets, which are so manipulated by central bank tinkering. Fed policies target major asset classes, not individual companies. Stocks are helped or hurt as a block by QE and rate changes. However, stocks and bonds behave differently. They are the most fundamentally different primary asset classes, and we own them in a target mix proven to work best through all environments.

I venture no guess as to where the market will go next, and I don't need to do so. A further sell-off - which is, of course, the warning of the weekend across all commentator lips - would see our bond allocations grow as a percentage of our total portfolio, leaving them nicely poised to buy the cheaper stock prices. A recovery would see our positions appreciate again. This is all normal to and fro, not to be feared or ogled, but just to be monitored and used properly.…

If you're moving a large amount of money into the automated plans, I suggest breaking your allocation to the growth fund into multiple buys to take some of the pressure off yourself to time it right. Eventually, your initial cost won't matter much once you get several quarterly rebalancings under your belt, but everybody naturally tries to time their initial entry. While waiting, put all of your capital in the bond fund. Move the portion into the growth fund over two, three, or four orders. This way, you'll feel fine no matter where the market goes in the short term, and in the long term it matters far more that you started the system at all than the initial cost basis at which you did so. This is counterintuitive, but true.

We can see evidence of this even in recent times. In last year's Note 62 sent December 22, Tier 1 was worth $719,652 and its growth fund traded at $108.10. This weekend, Tier 1 is worth $717,314 and its growth fund is at $105.63. The overall tier is down only 0.3 pct even as the growth vehicle fell 2.3 pct. If the growth vehicle keeps falling in price, the 3 percent signal system will continue moving more of its capital from the safety of bonds into the bargain prices of stocks. When a recovery eventually kicks in, the tier will grow its outperformance margin even more. Through successive cycles, the system widens its lead over its growth index, which itself beats the majority of active market managers. In this way, the elegance of mathematics upstages the exertions of zero-validity managers and commentators.

Not that this will ever deter the z-vals from guessing publicly about the future direction and timing of price movements.

Former Fed Chairman Alan Greenspan said on Bloomberg Television's "In The Loop" that "The stock market has recovered so sharply for so long, you have to assume somewhere along the line we will get a significant correction. Where that is, I do not know." The problem with this type of open-ended warning is that it offers no practical value. Of course the market will experience a significant correction "somewhere along the line" - just as it will experience significant rises and long flat periods, as well. It fluctuates up and down on a long-term trajectory higher. There is no reliable way to time entries and exits ahead of the fluctuations, so musing on their inevitability is unhelpful.

Ron Paul, the former congressman from Texas who is an outspoken critic of the Fed's monetary policies and the nation's fiscal ones, warned that runaway inflation is on the way due to Fed stimulus. He said on CNBC, "I think there's plenty of inflation, but my definition of inflation is a little different than the rest, because I think prices going up in the different areas is a consequence of inflation. There's a lot of inflation in the stock market. I think there's a bubble there."

His chief concern is that stock price appreciation has outstripped economic performance. "The growth isn't there. The only thing that grows is the debt, and just think about how much money they have to create value in the stock market. The unemployment is very, very bad, despite some of the optimism that is expressed with Wall Street, but that's all deception. I think you still have to see a healthy economy and people aren't complaining about structural employment, which is really insidious."

These are valid points, but they've been valid for the past six years and have yet to come true. They still might, but we can see that they're useless as market forecasting tools. Investing defensively against a comeuppance far in the future guarantees underperformance. The desire to profit from the stock market must include a willingness to experience its fluctuation. This is all we're discussing here. Investing strategies predicated on avoiding downside while capturing upside will fail. Dismissing occasional good luck, the best an investor can do is mitigate downside and magnify upside, which is what our signal system does.…

As for stocks and bonds, we'll keep automatically transferring capital back and forth between them in the fluctuations ahead. One advantage of relying on reactive arithmetic is that it disregards all guessing as to why prices went the way they did, and just signals times to buy and sell based on where they ended up after all the pressures were applied.