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Answers To The Four Biggest Questions In Investing!

Over the weekend, I was reading a piece in the S&A Digest via The Daily Crux (a daily article summary). They claim to have compiled the world's largest stock pile of past market data (my exaggeration) and then fed it through some kind of supercomputer to answer the holy grail of investing questions. Sounds a little too much like Wizard of Oz meets Mr. Wizard to me!!

Through this research they answer the "4 biggest questions in investing." Although I am not sure that you can limit the questions in investing to just four, I did find at least some for their analysis to be right on the mark, especially about trend following……….

1. Do stocks do well when the economy is doing well?

Surprisingly, they showed that stocks do better in a bad economy that a good economy. They state the reason for this could be the fact that the market discounts the strength of an economy in the pricing of stocks. In essence, by the time things are great, stocks are too expensive (and now due for a fall). The inverse is true in a bad economy. Another possible answer could be that our government (of recent) has applied more stimulus to the markets in a bad economy forcing stocks to do better than they might do otherwise.

Whatever the reason, they made the case that when GDP (Gross Domestic Product) is below 0%, stocks have historically returned 18.5% over the succeeding year. Alternatively, when GDP is great than 6%, stocks historically returned just 4.2% over the next year. In general, when GDP is higher, the economy is stronger.

2. Is the stock market cheap?

Here they stated that on an absolute basis the current stock markets are fairly valued at around 17 (price-to-earnings or P/E). The historical average P/E for the stock markets is 17.8.

I would make the case that no secular bear market has ever ended with stocks having a double digit price-to-earnings multiple, but I digress!

They then pulled out this nifty chart that shows that the higher the short-term interest rate, the lower this moves the market's opinion of whether markets are fairly valued. Inversely, they state a very low interest rate environment (like today) justifies a higher P/E.

3. With the markets reaching new highs it is dangerous to own stocks?

S&A makes the case that buying after a stock market hits its 52-week high has a compound rate of return of over 9.6% in the next twelve months. This is higher than the long-term "buy and hold" average return of just 5.6% a year. It is much higher than buying at the lows, which produced just a 6% return. These conclusions were based on 1950 to 2012 market data.

So in summary: "don't attempt to catch a falling knife (or market)" and "when markets hit new highs, don't sell, but buy."

4. Can simple trend following beat the stock market?

How about this for a set up? I couldn't have arranged for a better question!

The answer (drum roll please)?

Trend following does beat buy and hold averaging 8.4% vs. just 6.6% for buy and hold over the same 40 year period.

Their system used a simple 10 month moving average of market price and in Bear Markets moved to 90-day treasuries. I am assuming their buy and sell signals came from price moving up or down through the moving average.

Beyond the returns, which really only benefited by being out of Bear Markets, the account value differences are quite stark. An initial $10,000 investment became $250,000 using trend following over the 40 year period. While the same $10,000 only became $128,000 using buy and hold. What a difference!

Imaging what would have been the disparity had they actually invested inverse or short in the Bear periods!

So in conclusion, markets act differently than most of us would guess. They seem to rise more in bad economies. They appear cheaper when rates are lower. They (stocks) only feel dangerous at new highs. In fact, those that buy at highs do much better historically, than those who attempt to buy lows.

Finally, and most importantly, trend following works! Which is yet another reason to give us a free test drive for 30 days!