When making a case for any particular investment philosophy one normally has to resort to data and charts of past performance. So, on those rare occasions when current events serve to validate my position, I feel it only proper that I stand, basque in the spotlight, bow deeply and sincerely and take in the thunderous applause bestowed upon me by my audience. Well, absent that I suppose the only reasonable thing to do is review those events here in the hope that you learn and prosper in the future.
My Blue Blazer
Shortly after my last post one reader challenged my ascertains regarding the rally in gold. He asked, "Why do you think gold is going to go up?" I began by explaining that gold is priced in U.S. dollars; that the price of gold tended to move in the opposite direction of dollar value; and, with all the money being pumped into the system by the Treasury and Federal Reserve, the current dollar rally could not be sustained.
That evening on my drive home I mulled over that conversation. It occurred to me that I had left out a couple of important reasons: as well as dollar value, intrinsic value and available supply, the price of gold is also driven by interest rates, and inflation. With short term rates so low (and forecasted to decline further), investors will look for other places to invest their money with higher rates of return. Moreover, declines in the value of the dollar will probably mean increasing rates of inflation. Then, for no apparent reason, I thought about my blue blazer.
You see, when I was a young man I was taught that a blue blazer was an essential part of every man's wardrobe. At the time I didn't understand why and didn't really care much. It was the rule and that was that. As I became an adult I finally realized that a blue blazer works with five colors of slacks along with myriad shirts and ties.
With a blue blazer I was presentable at a job, lawn parties, and weddings. I was covered for roughly eighty percent of the events that called for a jacket. Therefore, I only had to concentrate on the other twenty percent of events (beach parties and black-tie affairs come immediately to mind) that I could be invited to. But, while having a fundamental understanding of why a blue blazer was so valuable, it didn't make the basic rule any more or less valid. Did it?
In the case of gold investing my rules dictate that when the closing price is above the 45 week moving average (WMA) for two consecutive weeks, we buy. When it closes below the 45 WMA for two weeks, we sell. Why I do that - at least initially - is unimportant. It's the rule I follow plain and simple. Over time it becomes apparent that the 45 WMA has a proven track record for investors. That observing the curve of the 45 WMA can reveal the strength of the uptrend. And, that studying the underlying index or commodity - if that is important to you - will provide some fundamental explanation as to why it is moving in a particular direction.
Is a 45 WMA rule the only rule you need to know? The golden rule (no pun intended)? Is this the "holy grail" of investing rules? No, no, and NO! The 45 WMA isn't correct all of the time. For instance, gold could move sideways within a range causing false buy and sell signals. But if we are on the right side of the trade eighty percent of the time, we can afford to learn from the mistakes that may happen during the remaining twenty percent of the time.
That final point is an important one. Every education has a price. For you to be a successful investor you must appreciate that the price of your mistakes is equivalent to tuition. In the beginning you will make more frequent mistakes. Assuming you study and learn from them, you will make fewer mistakes as you progress.
In terms of the gold rally that I wrote about you can see that the rally continued during Thanksgiving week and fizzled somewhat in the following week. From a purely technical standpoint, you can see that the current week's activity has covered the price gap established over the previous two weeks (the opening on December 1st was lower than the close on November 28th) and that the pricing trend continues to be upward.
Moving Average Rules - The Big Picture
[All right, I admit it, this piece is a bit dense with numbers. I tend to be very sensitive to this kind of writing because, quite frankly, my eyes tend to glaze over when paragraphs are filled with numbers. Still, sometimes it is essential to making a point. Trust me, I have edited this piece heavily to keep the numbers to a minimum. I urge you to read it and re-read it because the message is an important one.]
The S&P 500 peaked during the week of October 8, 2007 with a close of 1561.80. Using the two week rule, we would have exited our position during the week of November 12, 2007 when the index closed at 1458.74. And, in fact, we would not have taken a position again because there were not two successive closes above the 45 WMA. Since then the average has continued to sink closing the week of November 24, 2008 at 896.24. From our exit point those 562.50 points represents a 61% decline!!!
Now, much to my chagrin, as this market was in decent, one of my regular readers (MAF) told me that he was going to let his investments run. His reasoning was that he was young and could ride out the decline. On the one hand I admire him. He reviewed the facts available to him and made an informed decision. In fact, there is a line of thinking (discussed below) that would applaud such a decision. On the other hand, I'd like to hit him on the topside of this head!
First off, just for the S&P to get back to our initial exit position of 1458.74, the market has to rebound some 163%. The big question isn't if the S&P will come back, it's when
During the week of February 1, 2000 the NASDAQ surged 756.34 points to close at 4696.69. More then two years later (the week of September 1, 2002 to be exact) it bottomed at 1172.06. A loss of 3524.63 points or 75.04% of its value. It would take a 400% rally just to return to the its previous peak!
The rest of the chart reveals what has happened. From the September 2002 bottom the NASDAQ has managed to rally 240% to 2859.12 (October 2007). Yet, it is still 1837.57 points below its peak! [Oh my God, how many exclamation points am I going to use in this piece? Yikes!]
Yes, MAF is young but I would rather see him capitalize on the advantage of his youth. Cash is king in a declining market and whoever keeps the most cash is king. Again (jeez, will I ever get sick of writing this line?), in a declining market you are best served by exiting your fund positions and placing the cash in an interest paying account. You will buy a lot more at the bottom. Which is a great segue into my rant on Dollar Cost Averaging...
Dollar Cost Averaging (DCA)
Sometimes I think that the cliche rules we are taught in our youth are missing a line here and there.
Take the "Golden Rule" for instance. You know..."Do unto others as you would have them do unto you." I always said that the missing line there is, "Even if they don't!" I mean c'mon, you and I both know that someone else's act of rudeness isn't justification for a premeditated rebuke. Right?
The Dollar Cost Averaging rule strikes me much the same way. Investopedia defines it thus...
"The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time."
They go on...
"For example, you decide to purchase $100 worth of XYZ each month for three months. In January, XYZ is worth $33, so you buy three shares. In February, XYZ is worth $25, so you buy four additional shares this time. Finally, in March, XYZ is worth $20, so you buy five shares. In total, you purchased 12 shares for an average price of approximately $25 each."
That sounds great, doesn't it? Except for one thing: why would you knowingly buy something when there is a greater chance it will be cheaper next week? Who does that anyway? "Say, tell ya what...this index is trending down so, buy some this week even though it's going to be cheaper next week!"
I believe that the rule would be better if tweaked ever so slightly:
The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. This rule works extremely well in markets that are trending upward.
Let's go back to my previous review of the S&P 500. Given the extent of the decline, aren't we better off waiting for a clear signal that the market has changed to an uptrend before we buy? Instead of buying just some of our shares at a cheaper price aren't we better off buying the bulk of them at that reduced price?
Ending on a Positive Note
I am sure you have heard of Warren Buffett. Perhaps you've even heard of Peter Lynch or Edwin Lefevre. These men are among some of the legendary stock market investors. In their own way each of them convey the idea that, in markets such as the current one, it is important to keep your wits about you. It is also this type of market that led to the fortunes they built for themselves and other investors.
Coming up in The Market Informer...
At the end of the year we tend to reflect on the year just past and make resolutions for the year ahead. This time 'round the New Year is bringing some big changes to your 401k. I'll review those changes so that you know how to make the most of one of your most important investments.
I will also share some personal observations on the markets and the holiday season.
Questions, Suggestions & Email Subscription Requests are always welcome billmazzacca@gmail.com
All charts are provided courtesy of Barchart.com
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