Buy, Sell, or Hold?

Time to buy – or time to sell? Steve Sjuggerud, editor of the excellent advisory True Wealth, shares his model for knowing exactly how much money you should have in the stock market…no matter what the conditions: depression, war, boom or crash.

In just a few short months, chances are the stock market will do something it hasn’t done in the post-World War II era – it will have fallen for three consecutive years.

This has prompted many to claim we’re headed for a major bear market in stocks that could last up to a decade. On the flip side, pundits like Abby Cohen of Goldman Sachs tell us that stocks are undervalued and we may never see a better time to buy.

Who’s right?

With all due respect to my friends here at the Daily Reckoning, the answer never seems clear. There are certainly good arguments (on both sides). And regardless which pundit you choose to believe, you still have to decide on the big question regarding your financial assets – how much should you have in the stock market? After all, you don’t want to miss out. But you don’t want to get clobbered either.

Today, my aim is to help you solve this dilemma. I call my solution the "1-2-3 Model." And it couldn’t be simpler.

Green light – buy. Red light – sell. Yellow light – hold.

If you can understand traffic signals, you can invest with this model. Let’s begin… Using 75 years of weekly data, I crunched numbers until my fingers ached as if besought by arthritic fatigue. Now the signals are clear. The method for determining your stock allocation is simple. And it isn’t at all subjective…it doesn’t depend on any overpaid "analyst" forecasts. All you need to know is whether three core features of the market are working for you – or against you.

From there, the rest is easy. If all three features are in your favor, these are "GREEN LIGHT" conditions and stocks are a "strong buy." Under green light conditions, which have occurred 26% of the time since 1927, stocks have risen 19.5% a year.

If two out of the three factors are in your favor, well, that’s a YELLOW LIGHT. These are "buy and hold" conditions and they have occurred 50% of the time since 1927. Stocks under yellow light conditions have returned 10.7% a year.

If two or more out of the three factors are against you, hold your hat, because that’s a RED LIGHT. Time to sell. For most of the 20th Century stocks lost 9.7% a year under red light conditions.

Armed with this knowledge, you’d have known that we dropped into red light conditions in late 1999. You’d have adjusted your portfolio ahead of the collapse, and the stock market crash of 2000-2002 would have come as no surprise. You would know, too, that we’re still under red light conditions now. So…it’s not time to buy yet.

Back-tested for 75 years, the ‘1-2-3 Model’ has proven to work in all market conditions: depressions, wars, booms, you name it. I even checked each decade individually, and the results were always about the same – green light led to big gains, and red light mode was a portfolio killer.

What are the three market factors that make up the model? It’s best to phrase them in the form of questions:

1. Is the stock market expensive? 2. Are the Feds in the way? 3. Is the market acting badly?

Let’s look at each question closely: First, is the market too expensive? The clearest, time-tested measure of whether stocks are cheap or expensive, is the price- to-earnings (P/E) ratio. From 1927 until mid 2002, if you’d bought stocks when the P/E was above 17.0 (when stocks were expensive), you would have made only 0.3% a year.

During the test period, the P/E was above 17.0 about 36% of the time.

However if you’d bought when the P/E was below 17.0, which occurred 64% of the time, you would have made 12.4% a year in stocks. Right now, the P/E is significantly above 17.0 – therefore, the market is expensive.

That’s one strike…one out of the three criteria is already against us.

Second…are the Feds in the way? Interest rates are probably the biggest factor affecting stock prices. To understand it, simply consider this: If the bank starts paying 12% interest, what would people do? Well, if they’re smart they’ll probably move money out of the stock market and into the bank. It only makes sense that as interest rates rise, people sell stocks.

The interest rate movements that have historically had the most dramatic effects on the market have been changes in the interest rates set by the Federal Reserve – in particular, the Fed Funds rate. When the Fed is raising interest rates – look out!

When the Feds stay out of that way – that is, when they’re not raising rates – we earn, on average, 10.9% per year on stocks. This situation has occurred 71% of the time since the 1920s. However, for the 29% of the time the Feds are in the way, it pays to be cautious. Since ’27, stocks returned only 1.0% a year with the Feds in the way.

How do we define the 29% of the time the Feds are in the way? It’s simple. We look to see whether or not there’s been a rate hike over the previous six months. The Feds are out of the way either 1) after the six-month period has ended or 2) if the Fed cuts rates before the six- month period has ended. Right now, as I write, the Feds are emphatically NOT in the way.

So this factor is not against us. At least not right now. (But we’ll be watching events closely… this is one of the few times in history when the Fed has cut rates so dramatically and the market has failed to rally.)

Let’s take a look at the third component of the model: is the market going up? Market action is critical. No market model is complete without some indicator of market action. The market knows more than any "expert" can predict. Market action helps to account for the "human" element in the markets.

The Nasdaq didn’t rise from 1,500 to 5000 in two years on earnings or interest rates alone. Likewise, it didn’t fall from 5,000 back to 1,500 in two years on earnings or interest rates either. Human emotions are a very real part of the market. We need a simple, yet effective, tool to account for market action. And we’ve got one…

The market momentum indicator is simple. It’s the 45- week average of stock prices. If the market is above its 45-week average, stock prices are strong. If the market is below its 45-week average, stock prices are weak.

Sixty-seven percent of the time, according to our market action indicator, the market is strengthening. If you are in the market when this indicator says the market is strong, stocks return 12.6% a year. The market is weakening 33% of the time, based on this indicator. During this period, stocks have lost 1.6% a year. Right now, the market is weak. The index is below its 45-week average.

That’s two of three negatives…meaning we’re in red light mode.

In my view, these three indicators are the only things you need to know to decide when to put your money in the stock market. All the rest is just noise. You can ignore it. If you use the three indicators above, you will know whether you should buy, sell, or hold.

And what’s best about the model is, these indicators don’t change very often, so you don’t have to check the papers every day. Check in a few times a year. (I’m serious!) Stocks have been expensive for years. The Fed has been cutting rates for years. And the market has been acting badly for years. Had you been aware of the model you wouldn’t have had to spend any time stressing over the last two years – we’ve been in red light mode since late 1999.

Okay…so now that you’ve got a reliable stock market indicator, what do you do with this information? That’s fairly simple, too.

As a simple rule of thumb, subtract your age from 100. That’s how much you should have in stocks under "normal" conditions. I consider yellow light conditions normal. Under red light conditions – like now – you should cut that number in half.

For example, a 60-year-old man should have 40% in stocks under "normal" conditions (that’s 100 minus 60). But since we’re in red light mode, the rule is to cut that number in half, to 20%. It’s a simple rule of thumb, but a good starting point for most people, most of the time.

You can follow this model on your own. The P/E numbers appear in Barron’s every week, and on the S&P website. For interest rates, its all over the news if the Fed does something, which isn’t that often. And for market action, you can go to www.bigcharts.com to do the 45- week moving average. I also follow the model in my monthly advisory, called True Wealth. Once a month my readers check in to see exactly where we stand.

The solution has led readers of my newsletter to many great winners this year, with hardly any losers – in a terrible bear market. It also led my readers to lower their exposure to the stock market in plenty of time, as I’ll show. And best of all, regardless of what market situation we’re in, my readers know that we’ll make money in all market conditions.

And beyond solving one of your most important financial questions, by following this technique, you won’t be concerned about what they’re talking about on CNBC, what your friends are saying, and all the other things that ultimately have no positive impact on your investment success.

Instead, you’ll know what really matters. And you’ll be able to sleep comfortably at night, knowing that you’ll never miss out, and that you’ll always be positioned correctly. What more could you want than that?

Good investing,

Steve Sjuggerud,
for The Daily Reckoning
September 12, 2002

Editor’s Note: Dr. Sjuggerud is the editor of True Wealth, a wealth advisory designed to educate readers how to consistently increase their wealth over a lifetime of investing. Steve recently pioneered a "portfolio repair" program that has paid out 40% gains to his readers already in 2002 – and it’s backed by the U.S. government.

Housing, suggests a recent study published by the Milken Institute, has replaced gold as a "safe haven" in times of uncertainty.

"From 1945 to 1980," the Economist writes of the study "the share of property in households’ total assets are ‘positively correlated’ with GDP growth. But since 1980 they find a negative correlation: Housing becomes more attractive in times of slow growth. Until the 1980s, households invested [as if there were no human beings involved] more in housing as equities rose…by contrast, the recent fall in share prices has seen more money move into housing."

American ownership of stocks rushed past their love of property, ever-so-briefly, in the stock bubble of ’98- ’00. But investors currently hold about $11 trillion in stocks…and nearly $14 trillion in housing. Across the "rich" industrialized countries taken as a whole, the ratio of property ownership is much greater – with $23 trillion in stock ownership and over $40 trillion in property.

Sound at all like Bubble Economy, Round II?

Consider this. While the rise in US housing has been astounding in some areas…it’s only 5th on the list of countries experiencing a property boom. Britain has seen a whopping 40% increase in housing since the stock market peak in 2000. Spain, Italy, France, Australia and Canada have all jumped a minimum of 10%.

Trouble is, if these Western economies are anything like Japan – as your editors at The Daily Reckoning are wont to suggest from time to time – that "negative correlation" between plunging stock prices and skyrocketing property values is about to come unglued. After blistering price rises in the late 1980s – among widespread fears that the Japanese were going to buy up the whole planet – Japan’s property market has now slumped for 11 years straight…averaging a -4.2% year- over-year decline thus far in 2002.

The collapse in Japanese property values began in 1991 – two years after the beginning of the "Daddy" of all bear markets in Japanese equities. Neither have seen too many bright rays of hope since…

"We’re three years into this bear market," writes Richard Russell, "and stock valuations are still absurdly high. but we must remember that in a bear market values deteriorate through time."

"Japan is down for the count," adds our friend John Mauldin. "Europe is on the ropes. The world economy [appears to be] held together only by the willingness of the US consumers to still do their duty and buy. And that will only persist as long as jobs and housing stay afloat…it is a very unstable house of cards in which we dwell."

Eric, what’s your take?

******

Eric Fry in New York City…

– There was a lot of activity in Lower Manhattan yesterday, but very little of it had to do with buying and selling stocks. Just a few blocks away from my office next to the New York Stock Exchange, vast crowds of people gathered to remember and to mourn those who had died one year earlier. There were, of course, the usual throngs of tourists swarming about, snapping photos and satisfying some kind of morbid fascination.

– As a result of the 9/11 memorial ceremony yesterday morning, the NYSE did not open for business until about noon. Stocks launched a hopeful advance in the early going, but the rally fizzled by the end of the session. The Dow Jones Industrial Average shed 21 points to 8,581, while the Nasdaq slipped 4 points to 1,315.

– Ever since September 11, 2001, the US economy has lost its air of invincibility, while the stock market has continued to struggle. And yet, somehow, the housing market remains a pillar of strength. But is it too strong? Day after day, we read about the housing bubble.

– Obviously, most folks don’t believe all this bad press about the housing market, or they’d be scrambling to sell houses instead of scrambling to buy them. Prices would be falling, instead of rising.

– So is it a bubble, or merely a rip-snortin’ bull market?

– We can’t say for certain, of course. But home prices continue to rise at a brisk, bubble-like pace. Then too, prices are rising much faster than incomes, which is a very bubblesque phenomenon. Add to that the troubling little detail that mortgaged delinquencies are on the rise, and suddenly the housing market begins to resemble a large dirigible.

– Whether the housing market is a bubble or a bull market or something in the middle, the rising delinquency rate may be the bell tolling the death of rising home prices. According to the Mortgage Bankers Association of America, in the second quarter, a record 1.23% of all home loans were in foreclosure. That tops the previous record of 1.14% set in the first quarter of 1999. – "In recent years, the housing industry has bent over backwards to allow people…to buy houses they could not previously afford," the Wall Street Journal observes wryly. "Now, the bill is coming due."

– "The growing number of distressed borrowers is heightening fears that the nation’s red-hot housing market is poised for a correction," the Journal continues. "If the delinquency rate worsens, lenders could tighten lending standards, making it harder for many potential homebuyers to get financing and resulting in a weaker overall housing market."

– And voila, a housing bust is born. After years of soaring prices, many homebuyers have tended to forget that the housing market, just like any other financial market, is cyclical. And if we’re now heading into the down-leg of the cycle, our economy may be in serious trouble. As we’ve noted numerous times, consumers have been tapping the equity from their homes like sap from a maple tree, or the economy would be even worse off.

– "There’s a sinking feeling in the global economy again," says Stephen Roach, the bearish strategist from Morgan Stanley. "Country after country, region after region, growth risks now appear to be tipping back to the downside."

– Meanwhile, Roach points out the Mr. and Mrs. Consumer are not consuming with their habitual gusto.

– "The early read on back-to-school sales is disappointing," says Roach, "underscoring the possibility of the long-awaited retrenchment of the over-extended American consumer. At the same time, labor market conditions have started to deteriorate again."

– Too true, and labor market conditions weren’t that great to begin with. While the overall unemployment rate, at 5.7%, seems pretty decent for a sluggish economy, the "long term" unemployment rate tells a very different story. The legions of "long-term" unemployed are continuing to grow larger. 3 million people have been out of work for at least three months. That’s 1 million more than last year.

– "America, which led the world to the upside in early 2002, now seems to be playing a very different role," Roach concludes. "America’s double-dip scare of earlier this summer has quickly gone global…All this leaves the world economy exceedingly vulnerable. The global growth engine is sputtering again, and no new source of growth seems likely to immediately fill the void."

– So, as the saying goes, when the US sneezes, the rest of the world catches cold. But what happens if the US falls into a coma?…hmmmn.

******

Back in Paris…

*** Okay…so what do you do if the world economy is mired in debt, teetering on the edge of a housing collapse, and preoccupied with global terrorism and impending war in the Middle East?

Why, you make money…on soy beans and coffee, of course.

John Myers, editor of Outstanding Investments, has been profiled twice in Forbes over the last month for his excellent track record and recommendations stemming from turbulence in the Middle East. But yesterday he sent me this note: "I love to be the bearer of good news. In just a few weeks we have racked up triple-digit profits on not just one of our option plays, but on two of them! I’m talking about our coffee and soybean calls.

"Let’s look at the numbers. The coffee May 2003 70-cent calls we bought on Aug. 23 have been a windfall. We paid $0.0243, and they are now selling for $0.0546. That gives us a profit of 125% in just three weeks!

"The next week we ventured into another crop, and our return is even more spectacular. On Aug. 30 we bought soybean November 2002 $5.80 calls. We paid $0.065 for them, and they have also soared. They’re now worth $0.2625. That gives us a profit of monster proportions: 304% in just two weeks!

"That means that if you spent $10,000 on that single option, you now would have $40,400. With these kinds of profits on the table, it is imperative to grab the cash. And to quote my favorite saying again: ‘Be a bear…be a bull…don’t be a pig.’"

*** As you may or may not know, Richard Russell, Bill Bonner and Eric Fry – even John Mauldin, I’m told – will all be speaking at The New Orleans Investment Conference, among a host of other high-profile investment gurus. It’s going to be the investment event of the year. Anyone who’s anybody (or at least thinks of him or herself as somebody) will be there…

As I’ve also mentioned on occasion, we have secured a discount for Agora readers. Well, it pains me to tell you that the days you have left to register and take advantage of that significant discount are numbered. In fact, the exact number of days left is: 5.

Steve King, the guy responsible for securing the deal for you, informed me yesterday he will take discount registrations until 5pm EST Monday the 16th…and no later.

So, if you are planning to join us in New Orleans and want to do so by paying $300 bucks less than other attendees, I would pick up the phone and call Steve right now. Otherwise, the time will pass you by…and it will be too late. Steve’s got all the details. His number is: 800-992-0205…call right away.

We’ve already pushed the deadline back twice…after Monday, no more discount. Sorry.

Addison Wiggin

p.s. Bill’s in London today for a board meeting. He’ll be checking in tomorrow with a few naughty vicar stories, no doubt. See you then…