There has to be some method of reliably buying low and selling high. Of course, we've all bought cheap stocks and watched them get cheaper, or shorted at nose bleed levels, only to discover that the market can stay irrational longer than we can stay solvent. This article explores a number of ideas and tools aimed at gaining ground on the quest to buy low and sell high.
Ben Graham's Take
Chapter 8 of Graham's classic, "The Intelligent Investor", features a discussion of the issues, as useful today as it was when written. The two basic approaches are market timing and market level. Graham favored market level, as more logical for investors, and believed that market timers would of necessity degenerate into speculators.
However, he confessed to a discomfitting experience with his own "central value method" of determining indicated buy and sell levels for the DJIA. It didn't work. His final position was, that an investor could vary the proportion of stocks and bonds in his portfolio, based on a method of determining the level of equity prices, on an optional basis. He suggested investing when funds became available, other than when the market was at demonstrably high levels.
He discusses Bull and Bear market cycle theory, which at one point was regarded as fairly scientific, then goes on the cite instances where it didn't work, most notably the interminable bull market that led up to the Crash in 1929.
Finally he arrives at the strategy of buying stocks based on the asset values of the underlying business, a kind of low P/B strategy, which is often thought of as his primary method and insight. In practice, he was well aware of the merits of what he called "Goodwill Giants", referring not to goodwill as the balance sheet residue of acquisitions, but rather to the excess of market capitalization over asset values. Then as now that meant companies like Coke, Pepsi, or Procter & Gamble.
Working with Market Level
I determine the relative market level by using the ratio of the S&P 500 to GDP, looking back 10 years, and determining an average and a standard deviation. WIth this information, the level of the S&P can be expressed as a percentile, from 0 to 100, bell-shaped curve thinking.
After dividing market level into deciles, I looked at 1 year forward returns, using data from January 1960 to September 2010. In addition, I looked at the tails separately. Here's a table:
This makes a certain amount of sense. The sweet spot runs from 10-50, with returns averaging 10.81%. From 50-90, returns are anemic, averaging 3.58%.
The tails are counterintuitive. From 95-100 averages 12.03%, while from 0-5 checks in at 7.34%. During the tech bubble, the market stayed above the 95th percentile from May 1995 to January 2001. A carefree and optimistic investor could make huge returns, year after year. Of course it ended badly.
Not included in the data, when looking back on the bull market of the the 1920's, considerations of market level would have got the investor out well before the crash. The problem was, he would have missed at least two years of exhorbitant profits. There is the question, why anyone would want to pass that up.
At Tuesday's closing value of 1,195.54 for the S&P 500, the market is at the 28th percentile. Based on past history, it's reasonable to look for above average returns. If the S&P reaches 1,400, the 52nd percentile by this line of reasoning, expected returns based on history will not justify a heavy involvement in equities. Here's a table showing the S&P index values at various relative levels:
One concern, over the time period involved, the S&P 500 was in the 10-50 sweet spot 22.5% of the time. If the investor is only going to put his money into equities under these advantageous conditions, he will need to find other areas to invest in. The market doesn't spend much time at a happy medium level:
Knowing When to Bail
While market timing, in the sense of capturing short-term price fluctuations, is of little interest to those who take a longer term view, the experience of the GFC has convinced me that it's important and necessary to have an exit alarm, some definite signal that says it's time to take draconian evasive action. It might be needed only once in 10 or 20 years, or once in an investment career, but it's important to have it ready at all times.
The Philedelphia Fed publishes the Aruoba-Diebold-Scotti Business Conditions Index, hereinafter "ADS". It's updated as new data is received, and has a normal value of 0. While the website doesn't say so, it appears to be expressed in standard devations. A -2 level is seriously negative. Once things get past two standard devations, outcomes are very unpredictable.
My test has two considerations: 1) whether the index is over or under its 200 calendar day moving average, and 2) whether it's below -2. When it's under -2, and below its 200 day moving average, things are bad, and getting worse. It doesn't happen very often, and would have had the investor heading for the sidelines on 8/4/2008, when the S&P 500 closed at 1,249. By early March it hit 666 on an intraday basis.
The ADS gave a timely alarm, using these considerations, and did not give an alarm at any other time since the early 1980's.
The St. Louis Fed publishes the St. Louis Financial Stress Index, hereinafter "STLFSI". It's updated weekly, is constructed to give an average value of zero, and is expressed in standard devations, so that a reading of +2 would be very negative. The same test as discussed for ADS (with the signs reversed) would have gotten the investor out on 9/19/2008, when the S&P stood at 1,255.
The STLFSI gave a timely alarm, and did not give any others, on this basis, since its inception in 1994.
Neither of these indicators has been at levels I consider cause for concern as the US debt ceiling debate and Euro debt crisis unfolded. The STLFSI stands at 1.08: the ADS is at -0.2.
An upward crossover on the 200 calendar day moving average for the ADS, or a downward crossover for STLFSI would have given an accurate re-entry signal, in early March 2009, disregarding the level of financial stress or economic conditions. The thinking is, things are bad, but getting better. If the market is low, it's time to get aggressive.
Even waiting for the ADS to go over -2, or for the STLFSI to go under 2, would have permitted re-entry in May or early June 2009, with plenty of room to run.
This is not so much about fighting the last war as it is about getting some peace from macro issues. Time spent the intricacies of Slovakian politics, as the latest example, is not spent on constructive research on possible new investments, and may distract the investor from adequately monitoring his exiisting holdings.
Constant attention to macro issues and discussion exposes the investor to a lot of input, much of which is not data-driven. It may lead to decisions that are not data-driven, but instead rely on emotions of fear or apprehension. It may be better to set up some common-sense parameters for potential action and then just go about your business.
Also, market level is subject to much debate, all of it based on reams of data, and much of it contradictory. Developing an indicator of the type discussed here, and a few common sense observations of historical outcomes, much anguished debate can be avoided, and more time devoted to other pursuits.
Market level is in the sweet spot, a condition that doesn't always last that long. Based on history, a expected return of about 10% over the next year is realistic. Neither business conditions nor financial stress are at extreme levels that would dictate running for cover.
Disclosure: I am long SPY.
Additional disclosure: I am long Mutual funds based on the S&P 500 Index.