Stock Market Success

• Print
• E-Mail

You should know up front that I don’t purport to be an expert on the stock market or individual stocks. However, I’ve seen and traded thousands of markets over the years, both stocks and commodities. And over time, I’ve developed a feel for market trends. This issue of Commodities Trends has less to do with commodities than it does with stocks, but what took place last quarter in the Dow Jones Industrial Average and S&P 500 is so significant that I’ve devoted this issue of CT to it.

In a February 2006 issue of CT, I shared with you a powerful indicator to help you determine the major underlying prevailing trend in the stock market. We’re not talking about individual issues here, and certainly there are stocks that perform well in every bear market and others that do poorly in bull markets. Plus today, with all the exchange traded funds (ETF) out there--commodity based, currency based, and every shade and flavor--there are ways to prosper in all conditions.

But back to our theme, and as Jesse Livermore once said, "If you know the trend of the market, it’s hard not to make money." So if this indicator works, wouldn’t it be invaluable?

In a macro sense, this simple indicator has worked for more than 100 years now. It flashed a major buy signal for stocks in June 1982, with the Dow at 850 and the S&P at 101, and kept you fully invested without a sell signal for 19 years until June 2001. It didn’t get faked out during the 1987 crash--which we now know was short lived--and kept you in stocks during the dot-com boom.

The last time this powerful indicator told you to sell out your stocks was June 2001. It wasn’t the top, but what a ride. It kept investors comfortably on the sidelines during the severe bear market into 2002, when the Dow traded as low as 7,200 and the S&P as low as 770. The last buy signal was flashed in October 2003, with the Dow was trading at 9,000.

It kept you fully invested during the past five years, but with the Dow now trading at 11,300 and the S&P at 1,270, it just flashed a major sell signal June 30. That’s the first sell signal in years.

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.

OK, I can see you rolling your eyes on that advice, but before you give me a "thanks a lot for that," I’ll tell you that 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 when available and not to lose when profits are elusive.

Now I’m not talking about every trade or every investment. Of course, we all lose money at times. What I’m talking about here is to try not to ever lose big money, and when you’re fortunate enough to have paper profits significant enough to make a noteworthy improvement in your net worth, turn them into real cash.

A relative of mine once told me she was in on a dot-com initial public offering (IPO) from the beginning, an initial investment of $100,000. And at the top, she was worth $8 million on paper. That company is now extinct.

What was her net result? A loss of $100,000---she didn’t even cash in $1 profit--and, yes, she’s still working for a living. What was she thinking? I don’t get it. But then again, after a few decades of doing this, I’ve heard the same story in varying degrees time and time again. Therefore, there must be some psychological explanation beyond what we can understand.

To repeat, the key to wealth building is to limit your 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, oil, the government, corporate earnings? Indirectly, yes. But directly, the price is determined by the buyers and sellers in that market who might be influenced by these fundamentals.

In any case, what does it matter? We’re only concerned with the results in our trading accounts, a direct result of the price of whatever we’re trading. As you’re aware, I’m a proponent of the technical approach to the markets. I use a technical approach in my commodity trading. Below is a quarterly chart of the Dow Jones Industrial Average. This chart shows the time period between 1980 and 2001. On a quarterly chart, each vertical line represents one quarter, or three months of trading activity.

This chart begins with the end of the Carter administration (the start of the Reagan administration) through the beginning of the Bush administration, just after the dot-com bubble burst. Superimposed on this chart, I’ve drawn a 16-period exponential moving average (represented by the purple line).

Why 16? Many people believe the current administration is most responsible for the health of the economy and, by definition, the stock market. Sixteen quarters is the equivalent of one four-year presidential term. Although I personally don’t fully agree with the basic premise--it’s my view stock market trends are based on economic cycles only indirectly affected by any administration--this theory is still seductive. After all, the government does control fiscal and monetary policy, correct?

Still, it’s interesting to examine the stock market trends. During the Carter administration, the Dow primarily traded below the 16-period exponential moving average, a weak stock market during a poor economy in an administration that couldn’t seem to get a grip on inflation. The Dow and S&P moved above the 16-period exponential moving average shortly after the Reagan tax cuts and then closed above every consecutive quarter for 19 years, all the way up until the first quarter 2001 (the beginning of the current Bush administration).

It was only below the 16-period exponential moving average for that one quarter before it moved back above the second quarter 2001 numbers. But the third quarter closed below this line again and remained under this important average for the subsequent eight quarters. That’s two full years post-Sept. 11. After two years below it, the market closed above the average the last quarter of 2003, and it’s remained above since then, until now.

I understand this won’t be easy for most of you to do in practice, so here’s a simple methodology designed for safety plus above-average stock market returns: Remain fully invested in the stock market during those periods in which the quarterly Dow 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 over the past 20 years but over the past 100 years. I ran this average over the quarterly Dow chart for as long as I have data. That’s since 1900, and it worked superbly over time.

Consider this example: Following this methodology, you would have been fully invested beginning the first quarter of 1922 (when the Dow was trading at 80) through the second quarter of 1930 (when the Dow was trading at 227).

Remarkably, this program would have had you out of the stock market when the Dow was trading at 227 and kept you out during the majority of the Great Depression (when the Dow traded as low as 40 in the summer of 1932), with the next buy signal generated the second quarter of 1935 when the Dow traded at 118.

Bottom line: Although this method won’t catch tops or bottoms--and there were some false signals over the past century--in a macro sense, it’s now worked for more than 100 years. How do we use this today?

We just had a full quarter conclude. And because we base the signal on the close at the quarter end, the program has just flashed a major sell signal. The 16-period quarterly exponential moving average reading comes in at 11,725. Therefore, with the Dow closing the quarter out at 11,350, we have a major sell signal.

Sell out all stocks, and remain out now until the Dow closes above the average--a moving target--at the end of a future quarter. Therefore, the earliest we’d get back into stocks would be Oct. 1 but only if the market turns around and is strong enough to close above the average.

For the longer-term investor, this is an approach that avoids overthinking and will capture every major trend. What’s also nice about this methodology is that it will tell us whether or not 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 theorem remains the same.

If you want to be kept abreast of how this indicator performs in the future--i.e., when the next buy signal is flashed--shoot me an e-mail at geo@commodity.com with "Dow" in the subject line. To be totally clear, I’m not giving you financial advice here, just making you aware of a powerful stock market trend indicator.

And remember this sell signal could last for years. And if it does, you’ll be safe in cash or in alternatives--such as commodities--as the majority keeps praying and hoping for a new stock market bull.