Sunday, April 6, 2014

04/06/2014 How to beat market timers

In several previous posts I discussed Ned Davis’ observation that the S&P inflation adjusted returns tend to follow the birth rate 46 years previously.

The corresponding theory is that 46 represents the mid-range of productive adults. That includes workers in general (20-70), but even more specifically, entrepreneurs (35-55).  To start a business you need to have capital and the ability to take risks.  Below 35 and you don’t have much capital.  Above 55 and you don’t have much room for risk.

In the 2012 post I detailed how the demographics serve as a secular limit between bear markets and bull markets:

I pointed out in 2012 that we were nearing a secular limit that the stock market was unlikely to cross.

And after that 2012 post the stock market kept on climbing.

The popular explanation was that the current moves in the stock market were directly affected by QE.  I covered that connection in these two posts:

When something violates a historic connection, one looks for an explanation.  QE was the most logical candidate.

Ned Davis normalized his stock measure by using inflation adjusted returns, similar to the CPI adjustments Shiller builds into his CAPE ratios.

For the next two posts I used the ratio of 40-49 year olds to 60-69 year olds to create a kind of secular earnings yield.

The nagging problem for me was the fact that the market was just too high when using CPI as a control.  QE was a nice explanation, and it might well be true.


Then again, it might not be true.  There is another way to put the demographic forcing and stock prices on a similar scale.

What I’ve done this week is to map out the current deviation of birth rates and stock prices in relation to their logarithmic regression lines:

The blue line is the deviation from the mean regression of the birth rate in the past, and the red line is the deviation from the mean regression of the present stock market.

They align rather well.

There’s only one problem: the alignment is NOT the birth rate plus 46 years; it’s the birth rate plus 42 years.  That whopping 4 year difference is big enough to cram the 2009-2013 bull market.  That’s a big miss.

For the past year I’ve been speculating that the market should be relatively bullet proof into 2018, based on the demographic correspondence calculated by Ned Davis.

But if that correspondence is 4 years off, then my sunny appraisal into 2018 is also 4 years off: making 2014 a potential top.

To see how this looks, we apply the demographic deviations from the logarithmic mean of the birth rate and apply it to the present slope for the S&P regression line:


If THIS alignment is more accurate than the one Ned Davis proposed, then the secular bear market will end sooner.  However, the terminal dip for the present secular bear would begin this year, with a potential bottom for the S&P somewhere around 1300 in 2015.

The problem for investors is this: you just can’t use these long term calculations to time the market.  What are you going to do, just sit and wait for a decade?

And what’s the best alignment?  Let’s review:

1)      Ned Davis points out that the inflation adjusted S&P tends to follow the birth rate plus 46 years.

2)      Other sources point out that the ratio of mid working aged adults to retiring adults corresponds to the P/E levels of the S&P.

3)      And now this no-name blogger (yours truly) is observing that regression deviation calculations show the greatest match between the birth rate and the S&P with a 42 year offset, instead of 46 years.

Which is right?

Possibly all of us, since we aren’t matching exactly the same things.  But the maddening part of all this is the fact that these massively long time frames can’t be used as a timing tool.  To watch someone try and fail, check out:

Hussman is brilliant, and I love his analysis.  But he tries to use 10 year cyclically adjusted P/E ratios to time the market.  You just can’t do that without waiting through years of losses that you may not be able to survive.

Now, I do believe several things about market timing:

First, I’m not good at it.

Second, Hussman is no better.

Third, given enough time there is one direction that you know will be right.

And that direction isn’t down.

But still we time.  We’re fascinated, even hypnotized by it.  The patterns emerge with uncanny precision, and then quietly slip away the moment we think we’re on to something.  We time because we are afraid of taking losses, and we suffer losses because we time.

There’s a better way: stop investing in the market.

Read that last sentence carefully.  I didn’t say “stop investing in stocks.”  I said “stop investing in the market.”  The market will go up and down, and then up again – with any given 15 year period almost guaranteed to be profitable.  But you aren’t tied to the market as a whole.  If you pick stocks based on their company’s value, then in a world of 6500 stocks there will almost always be something reasonable to invest in.

The key to timing isn’t finding stocks based on the TIME they are going to go up, but rather on the PROBABILITY that they will go up.  You’ll never know when, but you won’t have to.  It’s like being able to bet on a horse at the track, but you can keep that ticket until he finally wins a race.  You can hold all day long, all season long, through the entire career of that horse, and you can cash in that ticket on ANY race that he EVER wins.

You’re barely gambling at all if you play that way.  You’re basically saying to the bookie “heads I win – but I can keep flipping until I hit heads and THEN I’ll ask you to pay.”

This isn’t to say that you can’t cut your losses.  But it is to say that a loss should NEVER be the result of bad TIMING, but rather of bad fundamentals that became apparent only after you entered the stock.  Facts do change, and companies do change.

But if you have a sound set of fundamentals you’ll be right more than you’ll be wrong – and being right about the fundamentals means that time is always on your side.

If you read my blog you know that I love to talk about market timing – but I never base my investment choices on timing.  Instead, I simply look for sectors and stocks that are priced less than they are worth.

Then I wait.

Anyone can win that kind of game.  Heck, it feels like cheating sometimes.  If I wait long enough, even the HFTs burn themselves out and move on to other investors to scare.

You know what?  You can do it too.

And you won’t even need sleeping pills to get a good night’s rest.





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