Great traders and true value investors know that it’s not only the return function that dictat...
Five Rules for the Wild Year Ahead
11/23/2010 9:25 am EST
Amid the market’s ups and downs, keep your eye on the long-term trend moving stocks upward. And should that trend break, prepare to run for cover.
Last week, in my November 19 column, I sketched out a picture of a very volatile 2011 and said that today I'd take my best shot at a strategy for how to invest through the turbulence.
I probably shouldn't be telling you this, but most of the time investing is pretty simple: Follow the trend with your money and get your emotions out of the way. And that's also the key to even as turbulent a year as 2011 promises to be.
My strategy is based on taking advantage of that "most of the time" and staying alert for the exceptions.
Most of the time, markets are in a trend. Look it up yourself on a chart of something as staid as the Standard & Poor's 500 stock index or something as supposedly volatile as the iShares MSCI Emerging Markets Index (NYSE: EEM).
If you graph the market's daily moves along with its 200-day moving average, you'll see that while the daily moves create a mountain range of jagged peaks and valleys, the smoothing average reveals a remarkably steady trend line.
So from March 2003 to December 2007, you'll see a 200-day moving average draw a very steady ascending slope. That's despite the big valleys caused by daily moves like those of March 2007, or the big peaks caused by daily moves like those of July 2007.
Even though it tracks a very different set of markets than the S&P 500, you'll see the same pattern in the Emerging Markets Index. The exchange traded fund tracks the index only back to 2003, but from May 2003 to June 2008, you'll see a very steady upward trend in the 200-day moving average. That's despite peaks like the one in April 2006 and valleys like those in May and June of 2006.
If you play around with these charts, a couple of really important investing truths pop out at you.
First, the longer your holding period is, the less important the volatility on the daily chart. Peaks and valleys fade into insignificance when you're looking at an upward-trending 200-day moving average from March 2003 to December 2007 or from May 2003 to June 2008.
This observation can easily get extended into something like the extreme form of what's called buy-and-hold investing, which argues that if your holding period is long enough, you need never sell stocks. You just hold on through any volatility.
Second, it's clear from looking at these charts that this extreme form of buy and hold isn't very good advice. And that's because these "most of the time" trends are punctuated by bouts of volatility that are big enough to completely reverse the 200-day or any other trend line.
The volatility from January 2008 through August 2009 (otherwise known as the global financial crisis or the bear market of 2007) decisively ended that March 2003-to-December 2007 upward trend. Same thing happened in the volatility that stretched from November 2000 to April 2003 (otherwise known as the tech bubble or the bear market of 2000).
Even if you draw a chart all the way back to 1950, you will see clearly these great trend-busting events. Some volatility is big enough to get your attention no matter how long your holding period.
Now let's apply these two observations to the year of volatility that I sketched out for 2011 and begin to turn them into an investment strategy.
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As scary as the volatility has been from, say, November 8 through November 18, it really doesn't matter much to you as an investor—as long as the trend that, in retrospect, began in July 2009 stays intact. (It took the rally that began in March 2009 until July to reverse the downward trend and establish a new upward trend.) In fact, the volatility of the recent ten days hardly registers on even a three-month chart of the S&P 500.
Second, as long as that upward trend in the 200-day moving average stays intact—and on November 19, the S&P 500 stood near 1,200 and its 200-day moving average around 1,125—then this volatility can help you. If you're a short-term trader, it's an opportunity to get trading. If you have a longer time frame, it's an opportunity to trim overweight positions (by selling) or to establish new positions or add to existing positions (by buying).
The more predictable these periods of short-term volatility are, the better the opportunities they create. If an investor knows that a stronger dollar/weaker euro will lead to a drop in the US market, then that's volatility that can be exploited. If an investor knows that worry over a tighter money supply in China and higher interest rates there will lead to a drop in China's stock markets, a tumble in other emerging country stock markets and to a retreat in commodity and materials stocks in the US market, then that's volatility that can be exploited. When you have something fairly concrete to track—the euro, Chinese monetary policies (or actually, the rumors surrounding them)— then you aren't just left with immobilizing fear. (For an example of how this volatility isn't inexplicable, see this post.) I would note that to exploit these opportunities, you do need to keep control of the size of positions you want to build in any particular stock. The point isn't to wind up with a huge position in a company just because its shares keep getting killed in short-term dips.
Volatility carried to an extreme can itself become a triggering event, so not all volatility can be shrugged off. It's one thing to say, Oh, here's an excess of fear over the Irish debt crisis that I can exploit because the odds are really good that the crisis will be over in a week or ten days and the fear will recede within that time span. It's another thing entirely to look at Portugal spiraling into default, triggering huge 3% daily drops in the S&P 500 that send everybody screaming for the exits as fear begets more fear, and try to dive in. (By the way, I'm not predicting a Portuguese default in 2011.) I think any default anywhere is extremely unlikely in 2011. I think we'll see a restructuring of Greek or some other country's debt in 2012 or 2013, after German and French politicians see that their voters can't be moved to extend another pfennig or centime of credit. Take a look at the Irish crisis if you want to understand why no debtor nation will be left behind, at least not yet. (Read "The euro zone gets desperate to push Ireland into a bailout deal" for more on this.)
And these rules hold true for 2011 only as long as the basic underlying long-term trend remains intact. That upward trend depends on three conditions, in my opinion: Nothing really unexpected happens in the euro zone; China's growth rate doesn't dip below 8% with signs that it is still looking to go lower; and the US economy doesn't slip backward from its current, inadequate growth rate of 2%.
To sum up this strategy for 2011:
- Use volatility that you find predictable as your friend to increase profits (by trading) and to control risk (by buying low and selling high).
- Watch for signs that volatility hasn't increased so much that it threatens to break the trend
- Keep your eye on the stability of the underlying trend and the three factors that support it. Go with the trend as long as those conditions are met. And if they're not, take steps to make sure your portfolio lives to invest another day.
And that's my rough strategic outline for investing in 2011.
At the time of publication, Jim Jubak did not own shares of any of the companies mentioned in this post in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here.)
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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