Wednesday, December 19, 2007

Remember Growth Funds?

They're back.

After seven years of dominance by value stocks, it looks like growth stocks are finally rebounding. The following chart shows the value and growth halves of the Russell 1000 since May 16, 2007:
The Russell 1000 Value index is down 10% in a little more than 6 months, and was 13% off its all-time highs at one point - just 7% away from an official bear market. Meanwhile, the Russell 1000 Growth index has actually gained 2.5% in the same time period, and it hasn't seen any drop greater than 7%.

I think this growth-value split is the beginning of a multi-year trend, so I'm weighting my long investments towards growth funds and ETFs.

Monday, December 10, 2007

Market-timing in action

My market-timing method has actually worked better than I anticipated it would. Here is a chart of the S&P 500 showing when I bought ultra-ETFs and when I sold them:

My new buy-in method is clearly illustrated here. I made four equally-spaced purchases in November to improve my chances of hitting the bottom, and I got pretty close on the 21st.

Even though the market has gone nowhere in the last six months, I've done quite well by timing my leveraged ETF purchases and sales.

Tuesday, November 13, 2007

My investment results so far

I do not immediately post my buy and sell signals on this blog, since I'm in a competition with other ETF investors on Fool.com, and I don't wish to give away my strategy to them.

My timing method, which I officially started using this summer, has significantly outperformed the market. I cashed out of the S&P 500 on July 13, (S&P 1552) bought back in on July 26 (S&P 1482) using the 2x leveraged ETF SSO, and cashed out again on October 8. (S&P 1552) Today the market is down 7% from the July 13 close, while I'm up 10% thanks to the July 26-October 8 gain in SSO. In total, I've pulled 17% ahead of the S&P 500 in about 4 months.

I am now committed to investing in the stock market's cycles in this manner. I don't see any reason to remain invested in long stock positions during a decline if I can see the correction coming.

Tuesday, November 06, 2007

1500 is key for the S&P 500

Since May of this year, a strong resistance/support line has been in place for the S&P 500 in the 1490-1500 price range.

In May and June the index never closed below 1490, but came within 10 points of doing so on 4 separate occasions. After plunging below 1490 on July 26 to start the most recent correction, the S&P 500 never closed above 1500 until the correction ended on September 18. Since the end of that correction, the index has bounced off of the 1500 level several times without closing below it.

So I think the S&P 500 index level of 1500 is key for the next couple of months. If the market closes below that level then I think it will have room to fall through the 1400's before recovering. But if the market can remain above 1500 though the winter, then I doubt we will see 1400 again.


Update - November 7: Just one day after this post, the S&P 500 obliged and fell below 1500 on its way to a correction. I now expect 1500 to be an upper resistance line until the correction is over.


Update - January 22: For the record, now that we're in the next "crash of the decade," I don't think S&P 1500 will have any relevance for quite a while.

Sunday, November 04, 2007

The Value/Dividend Bubble is Deflating

For the past few years the stock market has been suffering from a strange imbalance. On the one hand, value stocks and dividend-paying stocks are more popular than ever. This popularity is made obvious by (1) the relatively high P/E ratios of value stocks relative to growth stocks, (2) the amount of money invested in value and dividend funds relative to growth funds, and (3) the amazing run-up in prices of value and dividend stocks relative to growth stocks between late 2003 and early 2007. REITs and other real-estate related stocks were among the favorites due to their dividend payments, and they experienced a correspondingly large run-up in price.


But this value and dividend rally has occurred at a very strange time, because dividend payments - the very things that make dividend and value stocks valuable - have been disappearing. Since the peak of the tech bubble in 2000, corporations have been phasing out dividends in favor of stock buybacks. As a result, the yield of the S&P 500 index today is a near-record low 1.7%, well below the historic minimum of 3%. Even dividend-paying stocks are barely paying dividends today; the Dow Jones Select Dividend Index (ETF: DVY) only sports a 3.2% yield.

So why have value and dividend stocks outperformed growth stocks during the very time when they are producing the least income for investors? The only answer can be that we are in the middle of a value bubble, and I suspect that corporate buy-back money (which normally would have been paying dividends) has helped to drive up prices of cash-producing companies. Recent events have me convinced that this bubble is - if not bursting - at least deflating.


Stocks known for their dividend-paying advantages have been gradually veering south of the S&P 500's performance this year. In February REITs and financial stocks began to underperform, and they are now down more than 20% relative to the S&P 500. In May, the bulk of dividend-paying stocks followed as a group, and they are now down 12% relative to the market. Finally the entire value half of the market started slipping in June, and today it is already 10% behind the growth half.

I can't predict how long or how far this dividend "peel-off" will go, but I'm betting that growth stocks will be mostly unaffected since (1) growth investors aren't looking for dividends and (2) growth companies have less extra cash relative to their stock price to use for price-inflating buybacks.


Update January 22, 2008:

Duh! Growth stocks eventually succumbed along with every other group of stocks around the planet. I should have realized this might happen ... even though the bubble of 2000 was mostly growth and tech stocks, value stocks also participated in the subsequent bear market decline.

Monday, September 24, 2007

Currency Harvest Moves with the S&P 500

The Currency Harvest fund (DBV) is a great fund to own during a bear market, but it turns out to be a poor defensive fund during a bull market.
Looking back at its historical performance, DBV has experienced corrections of its own around the same times that the S&P 500 did. Such paired bull-market corrections include: 1998, 1999, 2004, 2006 and this year's July-August correction.

I require a defensive fund to go up during a correction more often than it goes down, and unfortunately DBV doesn't fit the bill.

Tuesday, September 18, 2007

A very good day

The S&P 500 closed near 1520 today, its highest point since July 23. That's only 2.2% below the S&P all-time record close of 1553, meaning we're out of correction territory.

Meanwhile, SSO is up 5.9% today and 14.9% from its correction low on August 15. There will still be some bumps along the way, but we should be in good shape as long as everybody else remains gloomy.

My indicators tell me S&P will reach at least 1600 in the next several months, which is a 5% gain from here and a 10% gain for SSO.

Sunday, July 29, 2007

Defensive Strategy Update

Perhaps I'm better at thinking about defense when I'm no longer invested defensively.

This week I discovered a great defensive pairing right under my nose: The Currency Harvest fund (DBV) and long-term US Treasuries (TLT). It's preferable to have defensive funds whose movements aren't correlated day-today, and it's ideal if they are actually anti-correlated. Since it was launched last year, DBV has been about as anti-correlated with TLT as one could possibly hope for.
As the above chart shows, one could have purchased the DBV+TLT pair at almost any time in the last 10 months without suffering any significant short-term loss. Each one of the "D"s on TLT's chart is a dividend payment which amounts to a 5% annual yield, so the average gain of the pairing is 10% (16% DBV with 4% TLT dividends) in less than one year.

At this point I'm not sure exactly why they are anti-correlated, since DBV doesn't place any bets on the U.S. dollar or U.S. bonds. It may simply be that any time global investors move out of U.S. bonds, they move in to bonds in other high-yielding countries - and vice-versa. Whatever the reason for this relationship, the DBV+TLT pairing will be the core of my next defensive position.

Wednesday, July 25, 2007

CSD is disappointing

It was fun while it lasted, but CSD is no longer beating the market. In fact, since June 19 it has actually underperformed the S&P 500 by 2%. I'm officially removing CSD from my portfolios.

There are two lessons here: (1) don't trust any individual stock fund for defense, and (2) don't rely on a specialty fund for long-term gains based on a few months of outperformance.

Friday, July 20, 2007

Gold and BEARX

It's officially defensive-fund season, and this has me thinking about the Prudent Bear fund (BEARX) again. Part of the strategy used by BEARX is to invest in gold-mining and related companies, since gold usually increases in value during economic downturns. These long positions are part of the reason that BEARX has actually been able to go up in value during slow market rallies.

Carl Swenlin on his Decision Point website points out that gold has been on a huge bull run since 2001, and may be poised to crash in the not so distant future. That run-up in gold has obviously helped BEARX over the last few years, and if Mr. Swenlin is right about the upcoming gold crash, then BEARX's ability to rise during bull markets may be coming to an end.

All in all, these concerns are enough to keep me out of BEARX. For the time being, I no longer recommend BEARX as a defensive fund.

Fame and fortune - actually just fame.

Yesterday I made a little news on the Motley Fool investment website. (fool.com) I was winning a summer stock-picking contest with over 1000 people participating, and the Fools featured me and my modest blog that I'm keeping on their site.

Saturday, July 14, 2007

Correction over - going defensive

The S&P 500 has closed at an all-time high of 1552, ending a strange little correction that began in early June. My indicators tell me that the market is vulnerable to a correction now, so I've changed my market stance to "defensive."

Back-testing returns

Leveraged 2x funds have been available for about a year now (June 2006), so it's time to back-test my current method to see how well it's worked. The market was at the bottom of a correction in June '06, a time to buy 2x leveraged funds. The S&P and investor sentiment both returned to their trend lines in November, which was a signal to change back to defensive funds.

The next correction began in February of this year, as indicated by the dip below the November price of ~1400. That was the second signal to buy 2x funds. By May the market had returned to its upper trend line, signaling a return to defensive funds.

The most recent correction followed quickly in June, dipping below the May price level of 1505 and returning (intra day) to the market's upper trend line on July 13.

The following table shows the returns using the most conservative 2x fund, SSO:

DateBuySellCumulative
Return
Buy and
hold S&P
June 16 '06SSO-0%0%
October 26 '06SHYSSO20%10%
March 2 '07SSO
SHY22%10%
April 25 '07CSD+DBVSSO40%19%
June 7, '07SSOCSD+DBV45%19%
July 13CSD+DBVSSO56%24%

Sunday, June 17, 2007

BEARX as a Defensive Fund

The Prudent Bear fund (BEARX) is the only true mutual fund that I've ever considered owning. It is actively managed, so it comes with a high expense ratio (1.75%) in addition to potential penalties (1%) for buying and selling within a month. Despite these shortcomings, I'm getting to like BEARX.

The Prudent Bear fund has an uncanny ability to go up in value during corrections (as any bear fund should) and during slow rallies - exactly the kind of behavior I'm looking for in a defensive fund. The managers use a combination of options, selling short, and buying long positions in certain companies to achieve these surprising results.

Now, this fund has not always performed well during weak markets. It actually fell 5% or so during the long downturn in 2004, and it's been pretty flat during the slow rallies so far this year. However, in combination with other funds that I've discovered more recently like CSD and DBV, I think BEARX provides exactly the kind of diversification that my defensive portfolio needs. In the short term, BEARX always goes up during corrections, so it makes sense to buy it during slow rallies. The probable, but not guaranteed, ability of BEARX to actually go up during slow rallies is then icing on the cake. If it rises with the S&P 500, great! If not, it's still providing insurance against a correction while CSD and DBV are doing their thing.

The following charts show BEARX (red) and the S&P 500 (blue) during the 5 most recent slow rally+correction phases. CSD and DBV are also included in the final two.


Wednesday, June 13, 2007

Why my method will work

Since the market dipped below the 1505 threshold that I marked in a post last month, I've been transferring gradually to the 2x leveraged funds, with one purchase made per day. Today I'm starting to see how this strategy will pay off, as the S&P 500 gained 1.5% and the 2x funds gained about 3% on average.

There is no guarantee that this correction is over, and it may not have reached bottom yet, but my portfolio will have made a substantial gain by the time the market recovers.


Saturday, June 09, 2007

Correction, Recovery and Trend

On the following graph of the S&P 500 I've drawn lines indicating the three phases of each market cycle:Red lines mark corrections where the market has fallen 5% or more from a previous high. (Note that the current correction has only fallen 3% so far.) Green lines indicate fast rallies (recoveries) where the S&P erases its earlier losses and reaches new highs. Yellow lines are where the S&P 500 returns to its long term upward trend, making steady gains at a slower rate than a recovery.

In the last 5 cycles over the past 2+ years, every single correction (red) has completely erased the gains from the previous trend phase (yellow). In other words, buying at the bottom of each correction, selling when the market returns to the trend, and holding cash until the next correction, would have been better than buying and holding the S&P 500 throughout the entire period.

Of course it's difficult to sit on the sidelines during the the trend phase and watch the market going up further without participating in it. That's why I've spent so much effort looking for funds which can result in net gains during the trend+correction phases of each cycle.

In hindsight it would have made sense to buy an inverse S&P fund like SH at the beginning of each trend phase, since it ultimately would have resulted in a net gain at the bottom of the following correction. But watching an inverse fund shrink while the S&P goes up is even more difficult than being in cash, since there's no way of knowing when the next correction will occur, nor any guarantee that the next correction will fall far enough to make an inverse bet pay off.

Currency ETF as a Defensive Fund

I've just discovered another new ETF which can act as a defensive fund. The Currency Harvest Fund (DBV) takes positions in 6 of the world's top 10 currencies based solely on their interest rates. It takes a leveraged bullish position (2x) in the 3 currencies with the highest interest rates, and takes short positions in the 3 with the lowest rates.

My understanding of why this works is that economies with high interest rates tend to attract foreign capital from people who want high-yielding fixed income investments, so those currencies tend to rise in value. Similarly, economies with the lowest rates tend to lose fixed-income investors. Since the fund takes positions in 6 currencies, a wrong move by one or two will not ruin the overall returns.

DBV already has an impressive track record of hanging with the S&P 500 in the long term while preserving its value through stock market corrections. Over the past 6 months, DBV (red) has actually outgained the S&P 500 (blue) by 2-1! (14% to 7%)

Impressive as that is, I'm more intrigued by what DBV did during the corrections. From February 20th to March 5th, when the S&P 500 lost 6% of its value, DBV lost only 3%.

In this most recent correction, the S&P was down by as much as 3% from its June 4th high, and today is down more than 2%. DBV has gained 1.5% since June 4th.


Friday, June 08, 2007

Defender: What have you done for me lately?

We've now been through two corrections since the Defender Fund (DEF) was created, and it hasn't defended diddly-squat.So I'm dropping DEF from my fund lineup. It will remain off my list until I see some evidence of DEF outperforming the S&P on down days - which was the whole point of the fund in the first place.

Monday, June 04, 2007

The Bull is Back!

It's official.

The stock market has broken its all-time record highs, meaning we are offically in a bull market. Hang on and enjoy the ride!

Saturday, April 21, 2007

That was fast.

Less than 2 months after the correction bottom in early March, the S&P 500 has already rocketed back up to a multi-year high. The prediction made earlier this month that the S&P would rise above 1460 has already come true.

Now the question is: how much higher will it go before another significant correction? My guess is that the market's rise will at least slow down at this point.

Wednesday, March 21, 2007

Surf's up!

Hopefully you managed to buy into a stock fund or two when the S&P 500 was down around 1380. Today the market is up over 3% from that point, and leveraged funds that move twice as fast as the market are up more than 6%.

I put 25% of my savings into leveraged funds when the S&P was near 1380, and now I'm thinking about when to sell. I'll probably start cashing out above 1450.

There's no guarantee that the market will go up more this week; it could plummet back below 1400 tomorrow for all we know. So now is probably not a good time to put more money into stocks. Always buy low and sell high, and wait for the right price to occur before doing either. Patience pays off in the stock market.

Tuesday, March 06, 2007

Has the market topped?

The Guru's latest forecast hints that the S&P 500 will not rise above the 1400's over the next several months. It's unusual for him to emphasize an upper limit to the market, especially considering that the long term forecast is still positive. If he is right, (and he's been right every time so far) then the market is going to bounce around in a relatively narrow range of values, and it will be difficult to make a lot of money.

The only way to take advantage of this kind of market is to buy bull funds near the dips (near or below 1400) and bear funds near the peaks (above 1450). Hopefully that way I can collect a series of small gains that add up to a big gain.

Wednesday, February 28, 2007

Predicting the obvious

Today there's a new article on Yahoo Finance titled "Why stocks are likely to move lower over next 6 months." After many paragraphs discussing how long it's been since the last 2% market drop, or about the number of junk bonds issued, the real conclusion finally appears in the last sentence of the article:

"... sometime in the next six months most Nasdaq stocks will be lower than they are today by at least 5%."

Huh? Is that a prediction worthy of the front page of Yahoo Finance? Have a look at the Nasdaq index over the past 3 years:

As you can see, the bumpy Nasdaq is no stranger to 10% or even 15% drops from time-to-time, so a 5% drop is pretty mild. In fact, if you made the "5% drop in 6 months" forecast at some random date, you'd have about a 50% chance of being right - without having to do any homework at all.

I have my own forecast for Yahoo's front page: "At some point in the next 6 months, the Nasdaq will be 5% higher than it is now." Both of these predictions will probably come true, so is either one useful?

Tuesday, February 27, 2007

Much-needed correction finally arrives

Today the S&P 500 fell 3.5%, putting it more than 4% below its closing high of 1458 last week. The last time the market saw this kind of dip was July of last year, and that was a great buying opportunity, as the market has since risen more than 17%.

Today's dip should also herald a good buying opportunity. Past corrections have dipped from 5% to 10% below previous highs, so I'll wait for the S&P 500 to dip below 1385, down to around 1350, before I transfer my savings out of bonds and into high-powered stock funds.

Thursday, February 22, 2007

Negative financial commentary bodes well for stocks.

One way to judge the market's mood is to read the predictions by market prognosticators. If the "experts" on Yahoo! Finance are any indication, the mood is downright gloomy right now. As has usually been the case, the market should move in the opposite direction of the mood, meaning we are poised for further gains.

Here are two articles on the front page of Yahoo! Finance today:

Are years ending in 7 bad for stocks? Apparently some bloggers have found that years ending in "7" have tended to be bad for stocks, so they are predicting that the market may go down in 2007.

Right.

When people start predicting that the number 7 will hurt stocks, you know that their emotions are making them look for a reason to get out of the market. Trust me, nobody back in 1997 was suggesting that you get out of stocks because of the number 7.

Stocks are headed for a fall. This article lists 9 reasons why the market is going to fall this year, mostly having to do with what the author sees as "market euphoria." Examples include Fox's plan to start a new business channel, (Did CNBC's creation precede a market decline?) and an increase in executive bonuses. (Wow, that's never happened before!) It's ironic that this commentator is aware of the contrarian effect of emotion, but that his own negative emotion is compelling him to look for "evidence" that has nothing to do with stock market optimism.

Just remember that gloom translates into money already sitting on the sidelines with nothing to do. This money will eventually flow back into stocks when the emotions change, and that will create real price gains.

The Ultimate Market Irony

George Costanza was a genius. The more I study the stock market, the more I realize that it pays to do the exact opposite of whatever comes naturally.

One result of this principle is already well-known: the wise investor buys when everybody else is panicking, and he sells when everybody else is euphoric. We're all human, so it's easy to get swept up into the wave of emotion that occasionally washes over the investor mob. Our emotions tell us to stay out of the stock market when everybody else hates stocks, even though such times are usually the best time to buy. Similarly, we are compelled to buy stocks when everybody else thinks that the sky is the limit, even though such enthusiasm usually means that people have used up all of their stock-buying power. So acting against the prevailing emotion may be difficult, but it is almost always the best thing to do.

But there is an even more amazing irony to stock market behavior. Partly because of the emotional component to stock prices, the market tends to be overvalued when the economy is strong, and undervalued when the economy is weak. In other words, it tends to be a good investment during recessions, and a poor investment during boom times!

This sounds crazy, right? Want proof?

Consider the early 1980's, the nadir of the recession that began in the 1970's. Inflation had reached 12% in 1980, unemployment peaked above 10% in 1982, and economic growth (GDP) was at a standstill. People were pessimistic about the economy, and stocks were very cheap - the market's P/E ratio was less than 10. Yet if you had purchased a simple S&P 500 mutual fund in 1982, you would have tripled your money in only five years, for an average gain of 25% per year.

That situation in the 1980's was quickly followed by the opposite case. After a small recession in 1992, the economy resumed its growth and corporate earnings doubled over the next 4 years. By 1996, things looked very rosy, and the consensus was that the sky was the limit, both for the economy in general and stocks in particular. But an investment in the S&P 500 at the end of 1996 resulted in a return of only 10% over 6 years, or less than 2% per year. People who bought stocks in the boom years of 1998, 1999 and 2000 fared even worse, losing up to half of their investment by 2002.

Pop quiz: In the last 100 years, when was the absolute best time to buy stocks? If you answered "sometime in the Great Depression," then congratulations - you're catching on! A purchase of Dow 30 stocks in July 1932 would have quadrupled your money in 4 years, (40% per year) and that's not even including the record-breaking dividends (up to 10%) paid out in the early 30's.

When was the worst time to buy stocks? You probably already know that it was 1929, just before the largest stock market crash in history. But do you know why the market was doomed to crash in the first place? For starters, the economy of the 1920's was so strong that it contributed to the decade being named the "Roaring Twenties." Yes, that's right: the economy was growing like gangbusters. And the stock market rocketed up right along with it ... to a point. The optimism of a strong economy and euphoria over an ever-rising stock market compelled people to buy ever more stocks by any means possible - particularly by borrowing the money. When the buying finally topped out, the market had nowhere to go but down, and down it went. The Great Depression began when stock-owning borrowers could no longer pay their debts. Defaulting debtors caused lending banks to go under, and the downward spiral began.

What's the situation today? On the one hand, the economy is booming again, stocks are expensive (P/E of 19), and yields are lower than they've ever been, (less than 2%) so history tells us that we should not expect large stock market returns over the next 5 years or so.

On the other hand, investors are not as euphoric as they were in the 1920's or 1990's. In the long run, pessimism tends to be followed by positive market performance, because investors have nowhere to transfer their money to except into stock funds. In other words, it's the opposite case of the overextended investors of 1929 and 2000.

So if the booming economy keeps stocks overvalued (P/E ratio above 15), and pessimism ensures future gains when investors eventually get back into stocks, then the market ought to make small-to-moderate gains over the next few years. Stated another way: pessimism ensures there will be gains, while the good economy ensures that the gains won't be large. It sounds insane, but history clearly shows that that's how the market behaves.