Guessing Is Not An Investment Strategy


JP Morgan (via Alphaville) looked at what would have happened to investors' returns had they listened to various bearish calls made by market strategists like Jeff Gundlach, Nouriel Roubini, Marc Faber and a few others. While there clearly are a lot of counter factual assumptions to create this sort of chart, it is obvious that rotating out of equities would have come with a substantial opportunity cost.

Just about any time there is a down day or two, stock market television will bring on a parade of people who are sitting on a lot of cash because they were concerned about whatever appears to be happening at the moment. The idea of "rotating out of stocks" is something that comes up frequently and these pundits talk about having raised a lot of cash, like 25%, 35% or more, because of their concerns about this, that or the other. These folks are of course citing valid threats to the market but unless they say otherwise, they are guessing about when is a good time to raise cash. Guessing will often lead to performance captured in the above chart.

One example of just what a bad idea this sort of fly by the seat of your pants guessing is, relates to politics. Many people thought the markets would tank under President Obama. Then a different group of people thought the market would tank under Trump and of course the market has rocketed higher over all that time. I agree the stagnation of the last 22 months has not been good but there's been no reason based on price to do anything but follow whatever strategy you believe in.

What if you guessed that you would get out after the last presidential election? When would you have gotten back in? That decision would have been another guess. What if that guess occurred last December, then the market had a fast decline, maybe confirming in your mind what lead you to sell after the election so you sold back out during that last week of December at or near the low? At some point on this treadmill you've permanently impaired your capital.

I've written more than 1000 posts on why I take defensive action when the S&P 500 goes below its 200 day moving average (DMA). When this occurs, it signals a problem with demand for equities. The problem may or may not be serious but a problem nonetheless. This process ignores politics and other biases by virtue of being price based.

Another huge departure from "rotating out of equities" for me is raising some huge amount of cash all at once. Detractors of the 200 DMA strategy cite how frequently it has been wrong, or at I might say, the number of times it turned out not to be a serious problem with demand. The next time a breach occurs will it be a serious thing or a three day head fake? There is no way to know now, there will be no way to know in real time, we will only know after the fact. Regardless of whether the next one is serious or not, we do know that the next breach will end after some period of time (long or short) and then the market will go back up. Subject to proper asset allocation, this means you don't need to entirely avoid the next large decline but it might be nice to avoid the full brunt of the next large decline which is what I am trying to do with all of this.

If fail to avoid the full brunt, you know that time will bail you out. In that context, I submit there is never any reason related to market cycles to go from fully invested to 30% in cash, or 20% or 40% all at once. True bear markets (not crashes like last December) start very slowly so reducing equity exposure can be done very slowly. Anyone who has been reading this blog for a while knows that I start defensive action with just one or two trades and those trades may not even been to sell, but to add inverse funds or something else that is designed to go up when the market goes down. Adding a couple of funds that go up when the market goes down combined with something like gold and a couple of sales (just a couple) will go a long way to avoiding the full brunt of a large decline. Anyone who can be nimble enough to sell more to avoid more? That's great but not essential in the way I am framing this.

The important takeaway is to not let a guesser who comes on TV or is quoted in something you read convince you to deviate from your investment process.