Using the S&P 500 as a measure of where we are today the chart below suggests that we are in a long-term consolidation and not just a brief pause in a long-term bull trend. As a fundamentalist and a Keynesian my inclination is to use charts to tell us where we are and where we have been - not where we are going.
Looking at the chart below one thing stands out - since 1950 we have had 3 distinct market phases. The first is the 30-year period from 1950 to 1980 representing a period of consolidation or stagflation if you prefer that term. The second is a major bull market spanning the 20 years from 1980 through 2000. The third is a new period of consolidation/stagflation beginning at the turn of the century and continuing through the present.
Each of these 3 phases are the consequence of monetary policies that produced these results. From the early 50s through the end of the 70s we had gradually increasing accommodative monetary policy that produced high rates of inflation peaking in the mid to late 70s.
Thereafter, Ronald Reagan and Paul Volcker forced the country into a de-leveraging period by raising interest rates. At the conclusion of the de-leveraging we began a period of unprecedented growth for the next 20 years. Today we are once again in a consolidation/stagflation period.
Bill Gross, co-founder of Pimco has made a number of comments recently referring to his belief that the days of high returns in stocks and bonds are over. He comments on the de-leveraging phase we are currently in and concludes that the days of easy credit are over resulting in a major paradigm shift for investors. His insight on where we are and what to expect going forward is worth the read.
If Gross is right - and he is - we are going to be confined to a broad trading range basis in the S&P 500 for some time to come. Those who buy and hold will not do too well. Those who can get a handle on timing the swings will perform much better.
Investors are frustrated today and for good cause. The glory days of the 80s and 90s are over and the buy and hold strategy that worked during this period has proven to be a huge failure since the turn of the century. If one had bought the market at the onset of the 21st century he would have had one chance to get out with a relatively small loss in 2007 and a second chance to get out with a small loss in the current rally. That's 12 years of going nowhere.
Some readers will be quick to point out that many stocks have performed and that it is simply a matter of being selective. Apple (NASDAQ:AAPL) comes to mind as one of those stocks and I would agree that if you own a crystal ball that allows you to predict the future you may well beat the broad market. Most of us don't have that crystal ball though.
The easy credit period of the 80s and 90s came to an end with the bank crisis in 2008-09. It was a game changer in many ways and a resumption of those days is not in the cards any time soon. Fundamental changes occurred for lenders and borrowers.
I have written a number of articles on the paradigm shift that we have undergone in recent years and recommend you read them. I have presented my own take on the structural change in the employment picture; failed fiscal and monetary policy; and the liquidity trap that was spawned at the outset of the banking crisis.
We are - as a group - creatures of conditioning and our expectations are based on what we expect to happen based on what has happened in the past. Pavlov's experiment with his dogs come to mind - we salivate at the suggestion of a resumption of the buy and hold bull market of the 80s and 90s.
If you believe that the playing field has not changed and that a buy and hold strategy will work then you are wasting your time reading this article. You will probably continue - just like Pavlov's dogs - to embrace the buy and hold strategy that has been spoon fed to us since the advent of the bull market in the early 80s. If you see the point Gross made and the point I am making then you might be receptive to making a mindset shift going forward.
To generate returns you are going to need to be a lot more proactive - alternating between risk on and risk off as we move up and then down and then up again in a broad trading range. From 1950 to 1980 the stock market went nowhere and the 21st century has taken on all the characteristics of that era.
There is still money to be made though. There are a number of strategies that one might consider but the focus in this article is on a single strategy that will allow you to move from stocks to cash and back to stocks. It works and you can prove it to yourself if you have the inclination to do the work it will require.
Rule based strategy
Let's set the stage. I am not a believer in chart interpretation. I am trained to recognize chart patterns and admit to watching the charts looking for double tops, saucer bottoms, head and shoulder formations, flags and pennants just like most traders. I just don't put any stock in their predictive value.
As a fundamental analyst I have a reasonably good grasp of Keynesian theory; money and banking; and accounting. I understand monetary and fiscal policy and how it impacts the economy. I believe in fundamentals and do trade off the fundamentals within the context of given price levels.
The problem with fundamentals is one of timing. I have discovered over the years that the fundamentals will - in the long run - prevail but in the short run a fundamental perspective can be a costly approach. Being the smartest guy in the room does not necessarily result in being the richest.
So there's the backdrop. What I do believe in is structured trading. By that I mean that you never enter a trade without a profit/risk ratio of at least 2:1. And you never enter a trade without a stop.
It means that you must learn to embrace losses. The best traders are wrong about 40% of the time but they make money because they make a lot more on their winners than they lose on their losers.
I wrote an article for Futures Magazine in January of this year that explains this concept. To drive home the point I set up an experiment that initiated a sequence of trades in the dollar index futures contract by flipping a coin and thereafter simply following my rule based strategy. The rule for this test: if the market moves in my favor by 2 standard deviations I exit the trade with a profit and reverse the position. If it moves against me by 1 standard deviation I exit the trade with a loss and reverse the position.
The result was a 38% win rate after flipping a head to start the sequence and an annualized profit of 70%. When I started out with a tail the result was a win rate of 50% and an annualized profit of 396%. The last 3 trades in both sequences converged meaning that going forward with the same strategy the trades under both scenarios would be the same.
The strategy does not rely on market timing - it relies on trade structure. In other words you won't risk more than 1 standard deviation and you won't take a profit of less than 2 standard deviations. With that kind of trade structure you can make a lot of losing trades and still make more money than any other approach I have found over the long run.
A word of caution - the rule used for the test is not the rule I use or recommend. However, it does make the point that a totally arbitrary entry point based on a flip of a coin can still yield a profit if the trade structure yields a profit/loss ratio of at least 2:1 and a win rate of at least 38%. I just can't emphasize enough the importance of trade structure.
Let's take a look at how this strategy would have performed using the rules I recommend on the S&P 500 futures contract this year.
The chart above uses statistical calculations to create a framework. The center line is the 90-day moving average or mean value. The lines that parallel the mean represent the calculated values for 1 standard deviation and 2 standard deviations above and below the mean.
Statistics tell us that 65% of the time the 1 standard deviation bands up and down form the mean will contain the next data point which in this case is the closing value represented by the jagged line. At 2 standard deviations the close will be contained within those outer boundaries 95% o the time. The chart above shows that this is true. I have run huge volumes of data and it is always true. The outer bands - given a large enough population of data points - will indeed contain the next data point to the 95th percentile.
Using my rules the S&P 500 futures contract would have made 7 trades since the first of the year with 4 winners and 3 losers. Total profits would have been $199.36 on one contract - a 16% gain on the S&P over approximately 9 months.
Trade results table
The rules for the results in the table above are straightforward. A trade is entered at any of the pivot points with a stop loss set at 1 standard deviation below or above the entry point depending on whether the trade is a long or short trade. If the trade moves a full standard deviation in the desired direction the stop loss is adjusted by a full standard deviation - the effect being a trailing stop that protects profits.
At the point the stop is executed the position is reversed and a new stop is entered above or below the entry point. The strategy above assumes a two way trade and keeps the trader in the market at all times.
A second strategy and one I would recommend for most traders is to simply go to cash when long trades are stopped out and wait for a new buy signal. The trades that are highlighted in the table above show the results of a one way use of this strategy.
The results using the one way strategy produced 3 winners and 1 loser. The gains year to date would be $204.55 - still about a 16% gain on the year. Of course if the market moves higher the current trade, which is still open will make additional gains. At some point it will reverse and the one-way trader will not realize the gain that the two-way trader will.
The reason for suggesting that the average trader stick with the one-way approach is simple. It is a lot easier to move from a buy and hold mindset to a buy and go to cash and look for a dip to buy again mindset. A lot of traders just don't like the idea of playing the short side and a lot of retail brokers discourage short trading. I understand that perspective and don't disagree with it.
As luck would have it the results as of September 18, 2012 using the strategy are pretty much the same results one would have achieved by buying the close on January 3, 2012 and simply holding the trade. If you would have done that you would have realized a gain through September 18, of $188.60 - pretty much a wash on the two approaches.
What is significant going forward is where we end the year at on the S&P. Under the strategy I propose the sell stop on September 18, 2012, is $1403. Assuming the pattern continues to move between the high end of the band and the low end of the band the S&P will work back to 1273 by year-end. What that means is that I would short the S&P at 1403.00 and if the market does move back to the lower end of the band the strategy proposed here would yield another $130.00 bringing total profits to $276.36. Compare that with a buy and hold strategy, which would end up the year at a $2.10 loss.
Characteristics of the pivot point strategy:
I use an excel spreadsheet to keep these data tables and charts on a wide array of stocks, commodities, bonds and currencies. I also keep shorter term charts - as little as 10 day mean value calculations. The shorter term charts result in a much more rapid move into and out of a trade. I don't recommend these short term charts as they are very proactive and they also get whipsawed a lot more. The trade frequency using short term charts is not well suited to the average trader. Over time the short-term charts do perform a little better than the longer-term charts but they can be quite frustrating when they go into the whipsaw patterns that occur frequently.
What I do recommend is a 90-day mean with standard deviations calculated from the open, high, low and close for the previous 90 days. The 90-day mean charts tend to stay with a trade for several months. Keep in mind the 90-day mean calculation is nothing more than a 90 day moving average.
Additionally, the charts are not magic. All they do is create a logic framework that allows a trader to implement a logical trade structure - that is 2:1 profit/risk parameters. The trade structure is the key to the strategies success in that losses are limited to 1 standard deviation and profits are at least 2 standard deviations.
It is crucial to understand that point. Although the chart does provide a reasonably good timing methodology the trade timing is not the key to success here. It is once again trade structure.
The other characteristic of these charts is that a very strong market in either direction can cause a few of the data points to exceed the outer bands. When that happens the assumption might be that the trend is about to reverse. That is absolutely not correct. What happens is the market tends to slow down and the mean value moves higher raising all the bands upward until the data points move sideways back into the band limits.
There are times when the market will hug the upper band for days and weeks at a time as the mean gradually shifts higher. The rule I use says that the market price must move back down to the stop in a bull market which is 1 standard deviation above the mean in this case. The strategy does not pick tops or bottoms - profits come out of the middle of the range.
Summing it up:
I developed this strategy 10 years ago and continue to use it today. It is a no judgment strategy in that it is automatic and can be used by anyone. Its success is predicated entirely on trade structure. The rules work over time. They will on occasion go into a whipsaw mode but the longer the data range used to calculate the mean and standard deviation the less frequent the whipsaw.
The rules are uniquely mine but the framework is used by others and some trading programs actually calculate the one standard deviation value and create trading channels with these values. I don't use these and my rules require the calculation of the 1 and 2 standard deviation values. These tables and charts are relatively easy to create using Excel spreadsheets and it takes me about an hour a day to keep them updated.
The strategy works. It is that simple. That does not mean every trade will be a winner. It does mean that you will make money over time using the strategy. Additionally, if by chance we do go into an extended bull market and move sharply higher the strategy will still work so nothing is lost by trading the swings.
As always - play it as you see it and good luck.