Can you time the stock market?

QUESTION:  What do you call an “expert” that claims to know where the market is headed?

ANSWER:  A liar.

Don’t trust anyone that claims to know what’s going to happen in the future.  The world is too complex.  The stock market, the weather, the mood of your spouse…there’s no telling.

Recall back to September 10, 2001.  Do you remember anyone predicting a terrorist attack the following day?  That’s an extreme example, but on 9/11 it only took nineteen hijackers to change modern history.  Now consider how one small insignificant event could cause your stock portfolio to drop 10%.  During any given minute, there are 7 billion people on earth whose actions could impact the market.  Factor in natural occurrences and it’s evident that long term predictions are futile.  It doesn’t matter how “super” the super computers get or how sophisticated the algorithm, the world is too complex.  Too chaotic.

The proper course of action is to make near term forecasts that are protected against catastrophic loss.  To paraphrase Ronald Reagan’s “trust but verify”, as investors we want to “forecast and hedge”.  (See prior article on the use of Protective Puts.)

As to near term forecasting, on an elementary level it’s comparable to observing the weather.  In San Diego if it were sunny and warm yesterday, and it’s sunny and warm today, there is a high probability it will be sunny and warm tomorrow.  If a stock had increasing earnings last quarter, and increasing earnings this quarter, there is a strong probability that it will have increased earnings next quarter.  Simplistic?  Yes, but that’s the essence of securities analysis.

Near term forecasting consists of two basic elements.  Fundamental and Technical analysis.  Fundamental refers to the stock’s underlying value- for example, a strong balance sheet and multiple quarters of increased earnings.  Technical refers to the stock’s price and volume action.

Combining the two elements, an investor can make near term forecasts on the direction of a stock.

As an example of near term forecasting accuracy, consider Investor’s Business Daily (IBD) market outlook.  Chart 1 is derived from IBD market outlook commentary superimposed on the SPY S&P500 index exchange traded fund.  Over the 21 month period IBD was directionally accurate in their outlook.  This type of forecasting is especially effective for a disciplined investor.  One that is patient and waits for the market to prove itself, thus avoiding market turbulence.

IBD UpDown Trend Chart

Being right even when you’re wrong…protecting your position with options

At Investable Wealth, LLC we strongly believe in protecting our equity positions with options.  A well researched position can fail for many reasons.  Stocks with excellent fundamentals and “proper” charts usually fail 30-40% of the time.  Add to that the threat of unforeseen news/events, a flash crash or just plain bad luck- no stock is immune from a dramatic price drop.

One method we use to help minimize losses is employing a “protective put” strategy.  Protective puts are sometimes referred to as “married puts” because both a stock and its put are purchased together.

The put’s value will move inversely to the stock’s…thus acting somewhat like a short term insurance policy for the equity.  If the stock increases enough to cover the premium of the put, then you’re in the money.  If not, your loss is limited to the cost of the put.

Here’s an example.  Let’s say that an investor was contemplating a position in gold following the Presidential election of 2012.  The investor is not concerned with a gloom & doom end-of-the-world scenario but is taking a prudent position (one taken by hedge luminaries like George Soros and John Paulson).  With the re-election of President Obama there are many concerns, including the implementation of Obamacare, Bush era tax cut expiration and the much overblown “fiscal cliff”.

Our investor in this example is forecasting uncertainty and turbulence in the market.  Rather than just wait things out in cash, he decides to invest in gold- anticipating at least a short term pop.  Gold has just broken through the 10 week moving average and he feels the technicals look favorable (see Chart 1) for at least a 12% upside.

IAU Protective Put EXAMPLE Chart1

He purchases IAU gold exchange traded fund (ETF) for a price in the mid to high $16’s and an April 20 $17 put for around a 3% premium.  Our investor is now able to sit back for the next 4.5 months anticipating his forecast of a 12% gain confident that a loss will not exceed 3%.

Over the ensuing months gold plunges more than 22% (see Chart 2).  The protective put limited the loss to about 3%.  Although the forecast was horribly wrong, the investor was still right (equity investments are not guaranteed, a prudent investor limits losses to 8%).

IAU Protective Put EXAMPLE Chart2