Tuesday, July 08, 2008

Graduation Day

With the S&P 500's drop into bear market territory yesterday, all of the market newsletters that have remained bullish since October 2007 have now officially blown their forecasts. I've been a subscriber of Bob Brinker's Marketimer newsletter for a couple of years now, and it is one of those newsletters that advised their subscribers to remain fully invested in stocks throughout the entire decline. I was already straying from Brinker's advice in June 2007, and I stopped following Brinker altogether in January 2008, so I'm not bitter about the poor forecasting. In fact, rather than rip on him for getting it wrong (like many subscribers are doing now), I'd like to express my appreciation for the things I learned from Marketimer.

The most important message that I got from Brinker's monthly newsletter is that the behavior of the overall stock market is not random, and can actually be predicted on long-term time frames. Most of the readers of this blog have probably accepted this fact by now, but I'll wager that most investors are completely unaware of this. From the moment I realized this truism, I made it my goal to figure out what Brinker was doing behind the scenes, and then to improve upon it.

Marketimer's goal is a simple one: to preserve capital by being out of stocks and stock funds during bear markets (20% decline or more). Brinker doesn't worry about smaller corrections of 5% or 10%, although he has taken advantage of them by signaling favorable times for adding any lump sum of new money to stocks. To predict the future value of the S&P 500, he uses a proprietary algorithm that combines factors like inflation, interest rates, and the average P/E ratio of the market. Some of the factors that Brinker takes into account seem like overkill; for instance, he actually keeps tabs on the esoteric money supply numbers. More to the point, now that he's missed a bear market forecast, his model obviously has shortcomings.

My first foray away from Brinker's method was in the summer of last year. Brinker was bullish as usual at that time, but my budding timing skills told me that a correction was imminent, and I cashed out of the stock market in mid July. A correction indeed followed, and I went back in 100% in late July, a bit earlier than the correction bottom in August. By October I had learned a great deal more, and when Brinker predicted that the S&P would rise to the mid-1600's in his October newsletter, I was again anticipating a correction, and I emailed a sell signal to friends and family on October 5th. The market top was 4 days later on the 9th.

Despite my success at out-timing Bob Brinker up to that point, I still used his newsletter as a safety net, figuring he must still be better than me in the long run. After all, he's Bob Brinker. Who the heck am I??

During that same period in the latter half of 2007, I was noticing very negative macro issues in the market that nobody else seemed to be talking about - including Bob Brinker. The dividend yield of the S&P 500 had been historically low for several years, and I was wondering: "shouldn't the market eventually drop back down to restore normal yields?" I also realized that certain market sectors were starting to fall while the rest of the S&P 500 was still rising. First it was REITs that turned south, then dividend-paying stocks followed, and finally the value half of the market started to dive. Brinker never mentioned any of it.

I also knew that corporate stock buybacks had been increasing astronomically for several years, to the point where companies were using almost all of their earnings to re-purchase stocks. It walked, talked, and smelled like a buyback bubble to me, and that would mean (1) that stocks are overvalued now thanks to the extra buying pressure, and (2) that when the buybacks eventually ebb, it would pull the floor out from under prices and the market would collapse. But nobody was talking about it.

So when the November 2007 market swoon came around, there were conflicting ideas in my head. My own understanding of market signals, technical indicators and fundamentals told me to fear for the future and stay out of the market, but Brinker's November newsletter was as rosy as ever, still sticking to the 1600's forecast. By the time the S&P dropped below 1400 in January, I realized it was time to take off the training wheels. That was the moment I graduated and stopped following Marketimer.

I now realize that market gurus like Bob Brinker rely too much on economic forecasts and market fundamentals - neither of which are very reliable predictors of future market performance. There are far more prescient indicators of the market's direction, and they have little to do with earnings per share or GDP growth rates. However, even though Bob Brinker doesn't use them, and even though he has now been completely surprised by a bear market, I still owe him a debt of gratitude. I wouldn't be the market timer that I am today without getting the idea from him in the first place.

4 comments:

John said...

Hi Jody, nice updates. It amazes me at the harmony the market moves in. Price and time are predictable to some extent. Nice call in October. Only after the fact did I notice the negative divergence. More symmetry as each of the rallies has been 30 points since 1440. Maybe this one is stronger. I think we need to retrace some of the 200 points before a panic can move us blow 1200. Just caught the cover of Barron’s. Contrarian?

Also, Interested in your opinion about the yield. I’ve noticed both PE and yield increasing? I have to wonder if yield will be cut and that could be a catalyst for more downside. Specifically C.

http://online.wsj.com/mdc/public/page/2_3021-peyield.html?mod=topnav_2_3000

Jody said...

Thanks, John.

I think yields are increasing simply because prices are falling. Remember, that calculation uses today's price, but the trailing 12 months of dividends. Prices have fallen 20% so far, and that would change a 2.0% yield to a 2.4% yield.

Earnings projections have been steadily declining for the past several months, so that would explain the increasing P/E ratio. In other words, "E" is falling faster than "P".

shadowclone said...

Hi Jody-

This is the first time I read about your blog. Very interesting insights. Just want to add that most of us are market timers to a certain extent. Who doesn't want to avoid the downs and profit from the ups only?

In all fairness, most of us (market timers) are only right sometimes but not all the time, including Bob. It would be difficult to maintain a good (not perfect) timing record over the long haul. What is important is whether we learn how to learn from our misses. What do you think?

Congrats on your graduation!

Shadow

Jody said...

I know plenty of people who are content to put their monthly retirement payments into stock funds without considering the direction of the market. In fact, many of the people I know picked their portfolios years ago when they began their jobs, and haven't made any changes since. Most people simply are not market timers.

I agree that those who do try to time the market should learn from their mistakes, and I'm constantly looking for ways to improve my method, but that's something I don't see Bob Brinker doing. He is still bullish today, and has yet to offer any fundamental revelation as to why he missed this bear market. If Brinker had admitted to making a mistake back in January, and offered to include a new factor in his model to prevent future misses, then I might still be listening to his advice.