I've mentioned before about the
danger of the current
stock market, especially for those with a buy-and-hold mentality and retirement funds. The mantra has always been that young investors with a longer time horizon, or those with a more aggressive investing strategy, should just continue to buy stocks regardless of the economic or analytic factors.
Occasionally we see a market, however, that is screaming a certain signal, and I would argue that now the danger signals are starting to blare.
BackgroundThe 200-day moving average in the S&P 500 has turned negative and started sloping downward in January of this year. More ominously, the S&P index price has dropped below that 200-day moving average. This is a rare occurrence, and has preceded prolonged market turmoil in the past.
Let's look at the history with three concrete examples over the past ten years.
| Strategy | July 1998 | Jan 2001 | Sept 2003 | Now | 10-Year Return |
| Hold Bonds | $500,000 | $564,000 | $632,300 | $725,000 | 4.5% Annually |
| Hold Stocks | $500,000 | $574,000 | $534,600 | $640,000 | 2.7% Annually |
| Two-Trades | $500,000 | $574,000 | $696,500 | $909,000 | 8.2% Annually |
The SPY exchange traded fund mirrors the broad market index S&P 500. Over the past 10 years, $500,000 invested with a buy-and-hold strategy would have become $640,000 with dividends invested, for an annualized return of 2.7%. Holding only safe US treasury bonds only for that period of time would have done better, yielding 4.5% annually, or $725,000.
If one were cognizant of the broad market direction as represented by the 200-day moving average, that investor could have made two trades and increased his/her return over $180,000 over a safe bond investment, and an eye-popping $264,000 versus stocks. Why is this important, and why am I harping about it now? We'll see.
History tells us that stocks tend to outperform bonds when the stock prices are trading above their 200-day moving average, and bonds tend to outperform stocks when the stock price is trading below it's 200-day moving average.
Two-Trades StrategyThe strategy is to sell stocks when the S&P 500 index drops below the 200-day moving average and buy them back when the index crosses back above the 200-day moving average. This has occurred only one time each in the last ten years.
Looking at the graph at the top of the page, July of 1998 was a heady time in the stock market with many financial advisers cautioning people to be careful of the market with the long upward trajectory that had been occurring in the 1990's and others pounding the table to buy, buy, buy. If an investors had eschewed cautioned and dumped his/her $500,000 lump sum into the S&P at that time, they would have had a nice run to 2000, with the SPY stock price going from $118 to $155 at the market top in March 2000. I picked the high for the month of July 1998 as the buy price just to be conservative.
From the March 2000 high, our investor would have continued to hold until the S&P crossed below the 200-day moving average in October 2000, a 12% drop from the absolute high. No investor is expected to catch the highest point to sell, in fact I would argue that most investors are not watching the daily or weekly machinations of the market. So, my assumption is that even the most astute investor would not have noticed the cross-over until the December 2000 low of $126 (again trying to be realistic and conservative)-- two months later and a full 9 months after the market high.
Why are these time frames important? Because that is exactly where we are now after the recent run.
In December 2000, our investor would have sold all his S&P 500 fund and put the proceeds, now $574,000 into a US Treasury bond fund--- I picked the conservative Vanguard Long-Term US Treasury Fund (VUSTX) for this example. The money would have stayed secure, earning 4.5% interest annually as the S&P 500 index sat below its 200-day moving average.
The S&P, represented by SPY, dropped to the low $80's and after a few weeks of gains crossed back above the 200-day moving average in April 2003 with an SPY stock price of $89... fully 29% below the sell price in December 2000. Nobody would expect even the most obsessed investor to notice this cross-over, so I assumed that they would not have gotten back into the market for another 5 months, until September 2003, and will use the month's high price of $102 as the buy-in price for the SPY, again trying to be conservative. For those 34 months in US Treasuries the money pile would have earned 4.5% annually for a total of $696,500.
Putting the $696,500 back into the S&P 500 in September 2003 would give us now in July 2008 a total of
$909,000 (including dividends) in the SPY!
A buy-and-hold strategy would have given us only $640,000---
$269,000 below the two-trades strategy.
Why am I talking about this now?
In January, the S&P crossed below it's 200-day moving average for only the second time in ten years. This has been shown to be a harbinger for a prolonged downtrend in the market. Currently, we are 19% below the October 2007 high, and 16% below the January 2008 cross-over point. My recommendation is to sell stock funds now and go into safe treasuries until the market crosses back above the 200-day moving average with some type of conviction.
Don't mention this to your financial adviser without expecting him/ her to chastise you about the perils of market-timing and the "advantages of buying for the long term", especially if your are a long ways away from retirement. Remember, some advisers have a financial gain in their clients being invested in stocks and stock mutual funds. Some advisers are rewarded for frequent trading into and out of stocks. Still others are more honest, but have been indoctrinated into the brotherhood with the belief in the almighty market and are too willing to take the hard times (with your hard-earned coin) as well as the good times.
I'm not going to bore you with all the narrative about impending recessions, bank failures, imploding housing market, exploding national debt, etc, etc, you can read
Barry Ritholtz for that. But I will point out that the S&P 500 has hit an important inflection point from technical analysis, and the red warning lights are flashing, so proceed at your own risk.
CaveatsWhat if I am wrong? Sure, the market does whatever it wants and this may be a profound bottom with the coming months being the rally of all rallies. Yes, I could be manifestly wrong (there, I said it.). That possibility would see the SPY quickly cross back above the 200-day moving average and we would find ourselves trading back into the market in a few months. I would argue that while that rosy scenario is possible and would see us miss out on a few percentage point gains, the real risk of losing another is 20% in the SPY from here is even more probable. The downside risk of holding US treasuries is minimal.
Are there better strategies? Sure, we could devise all types of historical models that look at gold, commodities, real estate, foreign equities, emerging markets, international bonds and currencies, small vs. large cap stocks in various markets.... but I would argue that that is overthinking it. The beauty of using the 200-day moving average crossover is that this is simple; it is an event that occurs rarely and appears to have had some predictive value in the past. This is not science, however, and we must be cognizant that are basing a decision on two events in the last ten years and thus attempting to predict the future on very little data.
What could be the worse case scenario in this strategy? The absolute worse case scenario is that the day after you buy US Treasuries the US government announces it is going to default on all of its debt thus making your "ultra-safe" treasuries which are backed by the "full faith and credit of the United States" essentially worthless. While extremely unlikely, I suppose it is possible. Of course, if that happens we would see a massive economic calamity and the SPY would plummet as well. The only safe investment would be gold, perhaps silver, and an assault rifle,
a la Mad Max.
Other negative scenarios? The US Federal Reserve could find religion and begin to raise interest rates in order to strengthen the US dollar, which likewise would depress the capital value of your treasury holdings since new money would be going into the new debt which would carry a higher interest rate. However, an abrupt increase in the federal funds rate would likewise lower the SPY and slow the economy as capital for investment becomes more expensive. In such a scenario, the dollar would increase in value, thus making cash king, but all other investments would weaken.
Can this model be tweaked in order to take advantage of alternate likely scenarios? Sure, but any tweaking would be based on unprovable assumptions and, more importantly, would complicate the simple process of trading only a couple times which is the true beauty of this strategy. Having said that, one could take this 200-day SPY cross-over as a cue to merely decrease their stock holdings in this environment and instead of going 100% into Treasuries, could stay in diversified in stocks but increase holdings in short bonds, cash and gold.
In short, the risk management model tells us the market is in trouble. Even if you eschew this advice and keep your stock holdings, at least be careful about new money into the market at this juncture.
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Conclusion: I truly feel the next five days will determine the market posture for several weeks. I am an inveterate market timer and it has served me well for a number of years. The 200-day moving average cross-over has me spooked, no question, but I am not out of the market as I type this missive. My retirement is currently allocated at 40% large cap, 15% mid/small cap, 12% international, 18% government bonds, 11% cash and 4% REIT's. I had been largely cash and treasuries from the fall until this Spring when I began to trickle back into stocks. If the current rally fails, say SPY under $120 on high volume, then I will look for opportune exits in the coming weeks and likely stay out of the market until the moving averages recover.
[UPDATE Aug 08, 2008]This information is for entertainment purposes only. Anybody who takes investment advice (or any advice for that matter) from strangers on the internet, needs their head examined.
