Stock prices don’t reflect P/E ratios or revenue growth.
Stock prices represent only one thing, the last price at which a willing buyer and a willing seller conducted a transaction. Their decisions are a function of millions of variables. Some investors use fundamental analysis. Others, including trading algorithms, use technical analysis. Many people dollar-cost average in or out of the market ignoring stock-specific information. No one can know what buyers and sellers are thinking when they make their investment decisions. The one thing and only one thing we can know is the price of the trade. When we see those prices on a chart, we know the trend. That’s where we look to make money.
Professionals on Wall Street know “The trend is your friend.”
Much like the disbelief that existed in 2009, the market trend reversed into a new bull market. The summer of 2020 was de ja vu. The “shock and awe” of a 34% S&P-500 decline in less than two months was a bear market. (A 20% or greater decline is a bear market). The rise in prices of the major indices has surprised even professional investors.
When markets decline, investors renew focus on risk management policies that are already in place. Typical asset class diversification risk management is simply reducing stock market allocation. Portfolios usually increase asset allocation to bonds. The allocation is based on Modern Portfolio Theory which applies long-term average market returns to each asset class.
Why? It simplifies sales and client reporting. It seems logical. It generates pretty charts.
You aren’t buying long-term average returns with your investment dollars. You are buying unknown future returns.
Current market prices seldom match average long-term prices. You can’t invest in any prior decade with today’s dollars.
Market risk is dynamic and probably does not match the average used to construct your portfolio.
Economic conditions today are likely not average.
Cash is not important when using Modern Portfolio Theory.
Whether making an investment today or maintaining a portfolio, today’s market generated information has priority in building and adjusting our portfolios. Specifically, our models treat cash as a separate and important asset class. Using current market data, cash becomes a primary portfolio position when market risk rises.
Anyone who mentions they were “out of the market before the big drop” has probably heard the response: “You will be too scared to get back in.” The fear is a natural human emotion for investors. Eventually it becomes “fear of missing out” or FOMO. It happens because most investors are ruled by emotions.
Process and discipline can be used to override emotions. Market generated information creates the foundation for our models and client portfolios.
Let’s consider the IR Relative Strength model used in company 401k accounts where Investor Resources is a fiduciary. A full explanation of the process was explained in our January Stock Market Update.
The straight and colored lines in the chart below represent asset allocation adjustment. The vertical lines segregate months. The model is limited by the thirty-four exchange traded or mutual funds approve by plan trustees. The asset allocation monthly rebalance is determined by Investor Resources application of market generated information and available in the January Stock Market Update. The 2020 S&P-500 chart follows.
The returns below do not include dividends or fees. Returns were obtained from www.TC2000.com.
The result was a $114,000 differential largely due to not suffering the majority of the February to March decline and rotating to new leadership choices at lower prices. Independently calculated 2020 return, net of fees and expenses was 37.5%.* The calendar year return on the S&P-500 was 16.26% plus a 0.83% dividend.
A primary rule for our models is to not own assets performing below our cash benchmark.
In February 2020, our market generated Macro Risk Information was:
View this chart as though you are driving through town. You instinctively know what red and green traffic lights mean.
At the start of January 2021, our Macro Risk Information was:
This process keeps client accounts current with today’s market conditions rather than an average of decades old returns.
Using market generated information to identify strength and weakness in global markets and the underlying components deals with reality rather than hoping averages will become reality.
Markets shift with adjustments in global economies, demographic and pandemic demand for products and services. Investors adapt by changing what they are willing to buy or sell in the capital markets. Price trends are an indicator of investors’ optimism or pessimism on any specific issue or asset class.
Ask us for a free evaluation of your present portfolio. Send an email to Help@IRIRadio.com or call 800-317-9119.