|Summary: There are different schools of economic thought on how markets operate, and how to predictably forecast their direction. Yet, rather than trying to pick market tops and bottoms, the best course is to ride the market waves and pull out at the right time.|
|Key take-out: Unlike aggressive trading, slow trend-trading aims to grow and preserve capital by minimising general market risk.|
|Key beneficiaries: General investors. Category: Growth.|
Last week I had lunch with Australia’s most interesting and controversial economist – Professor Steve Keen. Keen is one of those academics more celebrated abroad than at home. Watch his stoush with Nobel Laureate and New York Times columnist, Paul Krugman on YouTube.
In Australia, Keen came to the wider public’s attention when he trekked 225-kilometre to Mount Kosciusko with a T-shirt inscribed ‘‘I was hopelessly wrong on house prices – ask me how” after losing a bet with another economist. But Keen had the last laugh. When he started climbing Kosciusko home prices started falling, though they have still not crashed.
These days there are two main schools of economics, who call themselves “New Classical” and “Neo Keynesian”, but in fact they’re both branches of the “Neo Classical” school that began with Alfred Marshall. They’re a bit like the Catholics and Protestants of a century ago – arguing bitterly with each other over who’s got the right interpretation of the Bible. Then there’s a third group (let’s call them Minskians), snapping at their heels.
Keen, who identifies with Hyman Minski, Irving Fisher and Joseph Schumpeter, thinks that capitalism’s greatest strength – creative destruction through innovation – makes it inherently unstable. By contrast, the two other schools either think a market economy, after an external shock such as a natural disaster, war or government blunder, will automatically and quickly self-adjust (Neo Classical viewpoint) or that with government regulation and fiscal and monetary stimulus it can eventually be returned to normal (Neo Keynesian prescription).
Keen not only disputes the Neo Classicist belief that a market economy has an inbuilt tendency to stability, but thinks Neo Keynesian efforts to tame booms and busts will ultimately fail because that removes capitalism’s central dynamic, which is speculative risk taking.
In a recent series of articles in Business Spectator, Keen discussed these three schools of thought. These divergent viewpoints are important because they are a debate on why market economies get sick and whether they are self-healing, need intensive-care, or are just exhibiting growing pains which, if blocked, stunt their growth.
If Keen is right, then booms and busts intensify as markets become more deregulated and competitive. The following chart on S&P 500 earnings growth certainly suggests volatility is accelerating.
In Keen’s view, the Neo Classical belief that capitalism automatically gravitates to equilibrium (stability) is wrong and the Neo Keynesian belief that capitalism can be ridded of speculation without losing its dynamism is naïve.
Assuming that financial markets will become more benign (because we have learnt the mistakes of the GFC) may be wrong. Of course things may get better, but they may also get worse.
Having a strategy that can cope with either possibility is the best hope for both growing and preserving capital. The choice is not being optimistic or pessimistic, but being realistic. That means rather than trying to predict what might happen, a wiser course is to watch actual trends and then stay on the right side of them.
That’s especially true given that fundamental analysts agree investing in today’s sharemarket is more speculative than rational. In the above chart, S&P 500 earnings growth has now gone negative for the first time since the financial crisis.
My “conservative” trend-following share strategy has been on a buy signal since last July, and so has my “active” strategy, except for short pit stops when the market pulled back in November and March. I am riding this rally until it breaches its underlying upward trend. But how will I know that?
The chart below provides a crude safeguard based on 50 and 200-day moving average crossovers that you can apply yourself. Next time the red medium-term trend of the All Ordinaries share index falls below its blue long-term trend (known as a Death Cross), exit the stockmarket to avoid the possibility a correction becoming a crash.
Unlike aggressive trading, slow trend-trading aims to grow and preserve capital by minimising general market risk. Staying out of busts not only beats a buy and hold approach to shares over time, but does so with less volatility. There’s no better feeling than being out of the market when it’s tanking.
I time the sharemarket using exchange-traded funds like STW and VAS that mirror the All Ords index very closely, because they comprise the top 200 or 300 shares that dominate the exchange. Such highly diversified portfolios also minimise specific (i.e. individual) stock risk.
By using the market’s trend as your friend, it’s possible to ride booms and buck busts, whether they are an unavoidable part and parcel of capitalism (Minski and Keen) or an aberration that will quickly adjust of their own accord (Neo Classicists), or need government intervention to do so (Neo Keynesians).
Yes, there are occasional whipsaws (when an upward or downward price trend does not last long enough to make a gain or saving by trading it).my approach is to let profits run and cuts losses short, giving an inbuilt edge over a set and forget approach to share investing. Rather than forecasting the market (which is a fool’s game), I merely trend-follow it. The aim is not to try to pick market tops and bottoms (which is impossible), but instead catch the market’s big waves and then pull out of them when they lose momentum and start breaking.
Exiting the market on a “Death Cross” and re-entering it on a “Golden Cross” would have kept you out of the 2008 stockmarket crash, got you back for each rally since then, and should get you out again when the next bust occurs. Don’t rely on your instinct or forecasters to tell you when the market has passed its peak. Instead, let the market itself signal that by objectively timing its direction.
For the last nine months I’ve held the SPDR S&P/ASX 200 Fund (with the ASX code STW) in my self-managed super fund enjoying this amazing boom, but I also have a plan to sell it when the market next corrects. Anything else in this turbulent world is speculative investing.
Percy Allan is chairman of Market Timing Pty Ltd. For a free three-week trial of the Weekly Update bulletin and signals for trend-trading Australian exchange funds, visit www.markettiming.com.au.