A Sound Strategy for an Uncertain Time

by James B. Stewart

Monday, September 27, 2010

Is the stock market losing its predictive powers?

We know the market anticipates economic activity, which is why it's pointless to buy stocks only after good news has been published. Stock prices are one of the leading economic indicators used by the government to forecast economic activity. The rule of thumb has always been that stocks anticipate the broad economy by about six months.

But now that it's official, and we know from the National Bureau of Economic Research that the Great Recession began in December 2007 and ended in June 2009, the market's crystal ball is looking a little cloudy
The S&P 500 peaked at 1565 in October 2007. By late November it had dropped nearly 8%, but not the bear market drop of 20% or more that traditionally signals recession. And then, as the recession actually started, the market rallied, with the S&P reaching 1427 in May 2008. The market gave investors little or no warning of the grave crisis to come.

The S&P hit a bottom of 677 in March 2009, nearly three months before the recession ended, and rose a sharp 30% by May. That was a pretty clear signal, although the forecast came three months late.

Given that they reflect the collective wisdom of millions of investors, the markets may be the best prognosticator we have. But it's just not good enough. These recent results reinforce my belief -- and a fundamental premise of this column -- that no one can predict the future. It is not only futile but counterproductive to invest based on our feelings about where the market is headed next. Sadly, for most investors that approach leads to buying high and selling low, which is anathema to the Common Sense approach.

I believe in a disciplined approach to personal investing that minimizes emotions in decision-making, respects the past, which is knowable, and never tries to predict the future, which is not. I share my decisions in this column and the results are on display for all to see.

By following the Common Sense system, I never buy stocks at a market peak, and I never sell at a bottom. My aim -- successful so far -- is to buy lower and sell higher. I don't claim to have perfect timing. No one can identify markets tops and bottoms with any consistency. But my goal is to earn a profit, and over the long-term, beat the market averages. So far it's worked. (A hypothetical portfolio using the strategy would have outperformed the S&P 500 even during the most volatile stretch of the financial crisis.)

The Common Sense system is also simple to execute. It requires no computers or high speed trading capacity. Indeed, it doesn't require much trading at all, which is why you won't find a stock tip in this column every week. It's designed for average investors, not professionals. I'm a working journalist, not a stockbroker or hedge fund manager. But I firmly believe everyone can manage their own investment portfolios and outperform a simple buy-and-hold index approach.

Here's how the system works: When the market is dropping, I buy stocks at intervals of 10% declines from the most recent peak. When it's rising, I sell at intervals of 25% gains from the most recent low. (Createwealth8888: Quite similar to my investing strategy of buy slowly and sell slowly) These figures are roughly one-half the historical average losses of 20% in bear markets and gains of 50% in bull markets since 1979. They are round numbers and the math is easy to do in your head. I use the NASDAQ composite average as my benchmark, partly because I had mostly NASDAQ-listed stocks when I began the system, and also because the NASDAQ is a little more volatile than the S&P 500 or Dow Jones, which provides more trading opportunities. Investors who want to buy and sell a little less often might prefer another index, but the NASDAQ has worked well for me.

I always alert readers when a new threshold is reached and share my decision to buy or sell. The current targets are about 2025 and 2600.

Easy as this system sounds -- and it is simple in concept -- it's amazing how it difficult it sometimes feels. I remember vividly being at a cocktail party in October 2008. Everyone was boasting about their recent decisions to bail out of the stock market. When my turn came, and I said I had bought stocks that very morning, they looked at me like I was from Mars. The S&P 500 was trading at about 840 that day. On Thursday, it closed at 1125.

Of course there's much more to this column than reacting to broad moves in the market averages. As a journalist, I'm constantly translating news into investment strategies that I both implement myself and share with readers.

My overall exposure to the market may be constant, but I often substitute stocks and sectors. (Createwealth8888: Similar to my Noah Ark strategy, a pair of each kind is nice - sector rotation in buying and selling) Most of all, I find investing and thinking about markets to be both stimulating and fun. It's an adventure and a learning experience, as well as financially rewarding. I hope you'll continue to share it with me.