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How to Succeed in the Stock Market
by George
Kleinman
Editor, Commodities
Trends
February 21, 2006
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I picked these eight for dramatic effect. Because they’re high-price stocks, the dollar moves seem significant, but the percentage moves may not out of the ordinary. Is there any significance to this study? Probably not much--this small sample doesn’t show a trend. It’s the same with commodities. There may be a bull market or a bear market in stocks or commodities, but the important thing is this: What are your stocks or your commodities doing? With all the noise (random activity) out there, it’s not always easy to know what the prevailing long-term trend is, but I’m going to help you identify it. How do you know what to believe or what to do? I suggest you don't subscribe to either the bull side or the bear side. As Jesse Livermore once said, “I prefer to be on the right side.” It’s a bold title this go-round, so let’s get right to it. What’s the key to making money in the stock market over time? The answer is simple: Just don’t lose money during the down periods. I can see you rolling your eyes at that advice, but before you give me a (sarcastic) “Thanks,” I’ll tell you this advice is truly profound. One of the keys to success and wealth building is to turn some of your paper profits into real cash and not to lose when profits are elusive. I’m not talking about every trade or every investment; we’ll all lose money at times. To clarify: Try not to ever lose big money, and when you’re fortunate enough to have paper profits significant enough to make a measurable improvement in your net worth, then turn them into real cash. At my son’s wedding last year, a relative told me she was in on a dot-com IPO from the beginning with an initial investment of $100,000. At the top she was worth $8 million on paper. This company is now extinct. What was her net result? A loss of $100,000--she didn’t even cash in one dollar of profit (and yes, she’s still working for a living). What was she thinking? I don’t get it; but after a few decades of doing this, I’ve heard the same story in varying degree and detail time and time again. There must be some psychological explanation beyond what we can understand. So the key to wealth building is to limit losses during losing periods and accept gains during the good times. Sure, this sounds great in theory, but how do you go about it in practice? Let’s stop and think for a minute about how a price is determined. The price of a stock (or a stock index) is determined by what? The economy? The government? Corporate earnings? No on all three counts; the price is determined by buyers and sellers in that particular market. They might be influenced by these other factors, but they may not. In any case, what does it matter? You and I are only concerned with the results in our trading account, this being a direct result of the price of whatever we’re trading. I’m a proponent of the technical approach to the markets (I use a technical approach in my commodity trading), so let me present a novel approach I’ve developed to viewing the stock market. Below is a quarterly chart of the S&P 500 futures from their launch in 1982 through today. On a quarterly chart, each vertical line represents one quarter, or three months, of trading activity.
S&P 500 Futures,
Quarterly 1982-Present The S&P futures began trading at the start of the Reagan administration. Superimposed on this chart is a 16-period exponential moving average (EMA), as represented by the blue line. Why 16? Many people believe the current administration is most responsible for the health of the economy and, therefore, the stock market. Sixteen quarters is the equivalent of one four-year presidential term. I don’t fully agree with the basic premise--it’s my view stock market trends are based on economic cycles and are only mildly affected by a given administration--but the theory is seductive. After all, the government does control fiscal and monetary policy. It’s interesting to examine stock market trends. While we didn’t have futures pre-Reagan, if you used the cash S&P prices (or the Dow) during the Carter administration, you would have seen it trade below the 16-period EMA during that period; that's a weak stock market during a poor economy in an administration that couldn’t seem to get a grip on inflation. The S&P moved above the 16-period EMA shortly after the Reagan tax cuts, and then closed above that marker every consecutive quarter for 19 years, all the way up until the first quarter of 2001 (the beginning of the current Bush administration). It was below the “blue line” for that one quarter before moving back above it the second quarter of 2001. In the third quarter, though, it closed below this line again--and remained under this important average for the subsequent eight quarters, two full years post-9/11. After two years below, it closed above for the last quarter of 2003 and it’s remained above since then. Thanks for bearing with me; I’m coming to the main point. While I understand this won't be easy for most of you to do in practice, here’s a simple methodology designed for safety plus above-average stock market returns: Remain fully invested in the stock market during those periods the quarterly S&P remains above the line, get out and stay out (go to cash) during those periods it moves below. Bottom line: This simple system would have resulted in outstanding returns, not just for the past 20 years, but during the past 100 years. I ran this average using the quarterly Dow chart for as long as I have data (since 1900), and it worked superbly. Following this methodology, you would have been fully invested beginning the first quarter of 1922 (when the Dow stood at 80) through the second quarter of 1930 (the Dow was at 227).
Dow Jones Industrial
Average 1920-1937 Remarkably, this program would have had you out of the stock market at Dow 227 and kept you out during the majority of the Great Depression (the Dow traded as low as 40 in the summer of 1932). The next buy signal was generated in the second quarter of 1935 with the Dow at 118. While this method won't catch tops or bottoms, and there were a few--very few--false signals during the past century, in a macro sense it’s worked beautifully for more than 100 years. How do we use this today? As of this writing, the 16-period EMA is at 11,592. With the S&P 500 at 1,283 and following the program, we remain in the market. During the past few years, the program has had you fully invested, and that’s been OK. What would be behind a sell signal, should it occur? The stock market is a leading indicator of economic activity. Did you happen to see the recent trade deficit figure? It came in at nearly $80 billion for just one month, far wider than expected. Despite the recent weakness, oil prices remain high, in effect a tax on the consumer, who likely is already close to being tapped out. There’s only so much credit in the world and you can't refinance a major asset into oblivion. I guess my internal bias is bearish, and perhaps the market won't be able to hold up. However, our program indicates the trend remains up at this time. This is what impresses me about the market. Oil prices rose from $30 per barrel when the buy signal was generated, peaked at $70 and are about $58 today. Despite Iran and other global issues, stocks in general have held up well. The trade deficit has continued to rocket since the buy signal, and still stocks in general have held up well. What if oil prices continue to fall or the trade deficit narrows? This certainly would be a boon to the economy and, theoretically, would help the stock market in a dramatic fashion. Follow the money. For the longer-term investor, this is an approach that avoids over-thinking and will capture every major trend. And it will tell us whether it makes sense to be fully invested or totally out. I use a similar approach in my commodity trading (within a much shorter time scale), but the basic theory remains the same.
Risk
Disclaimer Hypothetical
Performance |
