CPM Investing LLC - Research and Investment Publications
The stock market has great gains sometimes, but it also experiences periodic losses. For many years —and still, to an extent, today—the widely-held idea in the investment interested was that one cannot time the stock market. Instead of trying to determine when stock prices hit a peak and rotating out of stocks, it became ingrained in the industry that it is better to maintain a stable allocation to stocks over long periods of time and to allow the benefits of asset class diversification provide lower risk.
Often, a 60% allocation to stocks and 40% allocation to bonds was (and still is) selected for the appropriate long-term allocation. When market movements pushed the portfolio away from these target allocations, one rebalanced back to the 60/40 weights. This is done monthly or quarterly. The prevailing view was that no one could time the market. No one could determine when the stock market was at a low point or a high point. Thus, it is better to simply hold stable weights of asset classes and derive benefit from the diversification benefit promised by modern portfolio theory and mechanistic rebalancing disciplines. The subjective view was more harsh: Only fools try to time the stock market.
The Event-Driven Model — and Its Shortcomings
A common belief of stock market price changes is that current events drive stock prices. Those events can include announced company growth figures; changing growth expectations of investors in general; news at the company, economy, and political levels; and natural disasters. If one can assess whether an event is good or bad for stock prices and also the magnitude of event, one can determine how stock prices will change. If you can forecast events, you can forecast the direction of stock prices. In the diagram below, stock market price level is shown in the brown line moving left to right horizontally over time.
People tend to see price movements related to news of the day, and this suggests to them that they can determine where stock prices are going by determining the directional impact of the event – good or bad for stock prices – and its magnitude. We hear in the news that an event has happened, and stock prices drop. This might be like Bad Event A, which, as shown in the chart above, drives prices lower. But eventually Good Event B comes along and pushes stock prices higher.
Based on the magnitude of the price change, Good event B must be very strong – prices move higher and pass the level where Bad Event A occurred and continue higher. However, Bad Event C must be very bad because stock prices move down dramatically thereafter. Good Event D must be very weak because it didn’t push prices very high.
There are problems with this approach. First, it is very difficult to find any single person or any single investment firm that can accurately forecast a long series of events—good or the bad— over long periods of time. There will be investors who can do that for a period of time, over couple of years or so. But then it might appear that they have a cold hand and are no longer successful in doing so.
Second, if one can forecast an event, the next challenge becomes determining its magnitude and impact on the stock market. Sometimes what seems like bad news can actually move stock prices higher. For example, if unemployment rates go up – clearly a bad sign for the health of the economy – stock prices may move higher because investors as a whole may conclude that the central banks will lower interest rates to promote economic growth, which is very good for stock prices. Thus, forecasting events and how the market will respond to them is extremely difficult to do successfully over long periods.
The Focused 15 Investing Approach
We do things differently. We don’t make long-term forecasts of political or economic events. Instead, we make short-term forecasts of how investors are going to react. By systematically evaluating how markets tend to react to news over time, we can see cycles of reactions. Over some time periods, the investors in general tend to react optimistically to news – be it good or bad. At other times, investors react pessimistically to news.
I am not the first to observe this. Many experienced strategists describe the tone or sentiment of the market as being important to understanding whether stock prices will move higher or low. What is unique to Focused 15, though, is how we measure this optimism and pessimism and integrate those techniques into an integrated approach to create model portfolios.
We describe the optimism of the market as creating market resilience. A lack of optimism results in a lack of resilience (which can also be called vulnerability). The concept behind resilience is that in a resilient market, prices recover quickly from bad news and events, and there is support for higher prices. Bad evens happen, but the rebound is complete and quick.
During the period depicted in the above chart, we can say that resilience is actually what’s driving prices higher. Yes, Bad Event A and Good Event B influence stock prices, but the major influence on the trend is the market’s resilience. As we move forward in time and toward the right of this diagram, the market has low resilience, or high vulnerability. Bad Event C is, therefore, seemingly driving prices quite a bit lower.
The good thing about resilience is that we can determine it using readily available data. This enables us to test decision rules for creating model portfolios over long period of time. While it is exceedingly difficult to assess events over a long period of time, we can look at resilience over as much price history as exists for particular index.
After we measure resilience over a long period of time, we can see that changes in resilience are rhythmic: there is a cyclicality to them. History doesn’t repeat itself, but it rhymes. Since market resilience is a function of human optimism and pessimism, we see that markets oscillate between overreactions related to excessive optimism and excessive pessimism. This human driver of market moves is remarkably consistent over time, regardless of whether the economic system is dealing with the Great Depression in the 1930s or the Global Financial Crisis of 2007-9.
An important point is that panic-selling tends to set in during periods of low resilience. Market prices decline surprisingly quickly in response to bad news when resilience is low (vulnerability is high). The extent of declines surprises investors who forecast events, and they question what they understand about the events they have focused on. In this time of questioning, they conclude that other factors must be at play and become uncertain. In times of high uncertainty, they tend to sell. More selling causes prices to decline further, and this sometimes leads to a panic.
Our model portfolios rotate out of asset classes with low resilience without waiting for any particular event to occur. If panic is going to occur, the vulnerable periods are when it will occur.
Market Resilience Index® Series
The Market Resilience Indexes (MRI) are what we use to measure resilience. The brown line from the last two charts is below decomposed into the larger trend.
The Macro Market Resilience Index (Macro MRI), in blue, measures these longer trends, which usually last for several years. The level, direction, and slope of that Macro MRI are important to assessing how investors will react to news of the day over the longer end of our 15 day to 15 week horizon for forecasting investor reaction to good and bad news . The Exceptional Macro is an alert on the slope change of the Macro. We want to know when the Macro MRI is likely to turn positive, and that is the primary purpose of the Exceptional Macro. The Micro MRI is like a heartbeat going across time, and the cycles are rhythmic and reasonably consistent cycles over time. These MRI indexes give us a good idea of where we are relative to historical norms for a given index.
Resilience is a function of the enthusiasm of investors worldwide: the greater the number of different views considered the better, and we can assess investor reaction to news. Unlike many investment approaches that depend on finding some overlooked opportunity or threat, the Focused 15 approach works best on widely-followed indexes like the Dow Jones Industrial Average. It is also more helpful for very liquid, widely-traded indexes. Resilience is measured by the small market price movements and return changes that take place in the index, so it is driven by price movements as opposed to price levels.
Trade After Inflection Points
At its simplest level, the Focused 15 approach buys low and sells high on the MRI. We are not trading the price, because the price is influenced by good news and bad news events that play out over time. Determining rotation trades based on resilience level is much more reliable than looking at price.
In general, if there is a cycle of resilience, shown by the green line in the chart above, a downward-trending line indicates lack of resilience, and an upward-trending line indicates resilience. We wait for the trough of an MRI and buy as it is moving up, and then we hold it as it’s moving up, and when it arcs over, establishing a peak, we will sell that asset in the declining leg of the cycle.
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