Swim with the Current
You've probably heard me say over and over that "80% of your
return on your portfolio comes from the market and the sector."
But what the heck does that really mean?
In June 1998, Investor's Business Daily summarized two studies
on the causes of stock- price movement in two books: The New
Science of Investing, by Dr. Robert Hagen and The Latent
Statistical Structure of Securities Price Changes, by Benjamin
King.
Those studies found that 31% of a company's stock-price action
was tied to the market as a whole. Industry group action
explained 37%, while broad sector action accounted for 12% of
the price movement.
Both studies concluded that only 20% of the price action in a
stock was determined by company fundamentals!
Unfortunately, most people were taught backwards. Most think
gains and losses are only determined by picking the stock with
the right fundamentals! Fundamentals are things like P/E ratio,
good management, growth rates, new products, market share, etc.
I'd venture a guess and say that most people spend 80% of their
time (and sometimes 100% of their time!) trying to find
the stock with the best set of fundamentals. Yikes!
So what happens when a company "with great fundamentals" happens
to be in a sector that's on defense? Or what if the whole market
is on defense? The company could see their stock price get
slammed (yes, even with great fundamentals!). Say you bought at
a stock a few months ago at $40. Today it is $20. The company
may still be growing like crazy, but the market or the sector
dragged it down. If the story didn't change, then didn't the
fundamentals just get even better? It has to be a better value
at this price, right? If you invest by using only the
fundamentals, you lose.
Again, most of the returns you're going to get will depend on
whether the market (and the sector the stock belongs to) is on
offense or defense.
Look, everyone knows that if you're swimming with the current,
it's an easier ride. There are times when the market is on
offense (and you're moving with the current). Hey, it IS
possible to make money when the current is against you. But the
odds are stacked against you! So, try to swim with the
current...swimming against the current is NOT recommended!
Offense? Defense? Huh? When we're on offense, we run
offensive plays from our playbook. Meaning, we'll look to put
money into the market to build our wealth. We're not going to
buy everything in sight; we want to focus ONLY on the sectors
that are also on offense.
When we're on defense, we'll run plays designed to protect our
assets. "Defense" doesn't mean run out and sell everything!
What's the goal when the defense comes on the field in a
football game?
To prevent the other team (the market) from scoring against
you!
When the market is on defense, we'll only call plays from our
defensive playbook. Running a defensive strategy helps prevent
us from making really stupid mistakes in our account and taking
big losses. "Defense" can mean taking steps like buying
protective puts against your holdings. Or possibly shave back a
large investment in a stock or mutual fund.
Avoiding big losses alone will improve the performance for
most people in the market.
How do we know whether to be on "offense" or "defense?" We use a
tool that is an excellent indicator of the level of risk in the
market. Fifty years ago, a technical analyst named A.W. Cohen
came up with this tool he dubbed "the bullish percent index."
Cohen was looking for a way to tell when to be cautious near
market tops and also aggressively optimistic near market
bottoms.
If you think about it, isn't that what we all want? Something
that'll tell us when the risk in the market is high...and when
the risk in the market (or a sector) is low! And it's been
around for fifty years, ignored by many in the market!
The bullish percent index is the percentage of all the stocks in
a universe that are currently on buy signals. Now, that
"universe" may be all the stocks in the semiconductor or the
financial sector. Or even all the stocks listed on the New York
Stock Exchange.
Knowing when the risk is high in a particular area will go a
long way toward improving your investment results!
When to take action We've discussed the bullish percent
is all the stocks in your group that are currently on buy
signals. We feel it's the single best "risk level" indicator we
have found. But how do you know when to take action?
If 90 out of 100 stocks in a given sector are currently on buy
signals, the bullish percent index is said to be at 90% for that
group. If only 30 of 100 are on buy signals, the bullish percent
is 30%.
Now, if 90% of all stocks in a sector are already on buy
signals, that means only 10% of the names in that group are NOT
on buy signals.
We'd want to be cautious with that kind of high reading!
Hey, no one likes being the "last guy" to show up at a party,
but that's what happens to a lot of individual investors. They
get in near the top and get creamed when the sector or market
takes a dive.
Now, what we're measuring here is supply and demand. When there
is demand, prices rise. When a sector reaches 90%, there's not
much more that can move a group higher.
But that's NOT the time to sell.
See, stocks can hang around lofty levels for a LONG time. It's
only when we see more and more companies in a sector (or market)
start to give sell signals, we know that supply is overtaking
demand. When that happens, lower prices are on the way.
Now, say last week we noticed that a sector had a bullish
percent reading of 30% and this week it's now at 38%. This is a
group we'd want to pay attention to! Not only are the readings
going up, they are going up from low levels!
This is precisely the stuff we zoom in on when telling you where
to put money to work!
Predictions
If we need to get out of something, we'd sure like to know it
NOW, not later!
Hindsight IS 20/20. But it won't help you avoid losses in your
account. We've given up predicting what the market will do
because we use tools that tell us accurately what IS happening
right now in the marketplace. The point and figure charts we use
and the bullish percent index are tools that tell us what's
happening today. These charts tell us what is in demand and what
is in supply.
There are too many folks trying to complicate the investing
process. Keep it simple. Just remember that anything with too
much supply will see their prices fall. Anything in demand will
see their prices rise. And we have a method of measuring exactly
which stocks and mutual funds are in demand and which are in
supply.