Sunday, 1 August 2010


T H E    Q U I C K    A N D    T H E    D E A D


I N   T H I S   T O W N ,  
Y O U ' R E   E I T H E R   O N E   
O R   T H E   O T H E R

When it comes to investment decisions, are you Gene Hackman or Leonardo di Caprio? Are you a swashbuckling risk-taker, or a cautious, hard-bitten wallet-warrior?  Are you quick - or are you dead?

I started this blog last year as a way to keep those close to me, most of whom aren't familiar with the world of finance, alert to the latest treacherous twists and turns in our journey through what have become, in the words of that wretched old Chinese curse-monger, 'interesting times'   I hope some feel at least a little better informed as a result.  However I must admit I've had a surprising number of requests for personal advice, and I've even had offers from a couple of friends to manage their investment portfolios for them.

Naturally I'm flattered, but I have trouble enough keeping my own finances in shape never mind worrying about anyone else's.  Yet the requests are a prodding reminder that, no matter how brilliant, savvy and dinner-party-ready my readers may have become by reading On the Money, the day-to-day practicalities of holding on to the stuff and making it grow are an entirely separate challenge.

This is especially true now, as the comforting certainties of our brash thirty year boom have all but turned to dust.  Gnawing concern and downright pessimism have seeped into our economic world-view and with good reason.  Even opening a puny savings account in 2010 means taking on a risk we'd never previously needed to consider - on top of the growing, multifarious risks to those pension, share and property investments we were once led to believe were bound to go up.  Markets are more volatile than they've been in three-quarters of a century; many hardened Wall St operators are calling this the trickiest trading environment they've ever seen.

So if you're invested in markets in any sense, whether through a simple stocks-and-shares ISA, a personal or company pension or a full-on trading account, speed and responsiveness in unfamiliar investment terrain is more important today than it's ever been.  To return to our theme, we need to be channelling Gene, not Leo, because this is one town where you'd better be quick, or you might just wind up dead.


In between my monthly spoutings I do post ideas on various opportunities and risks in stocks, property, bonds, savings etc. etc. but all things considered it's rather patchy and, from a long-term investor's point of view, somewhat unsatisfying.  I've decided that this has to change.

So, rather than rehearse yet one more rant against the same old enemies, this month OntheMoney is taking a decidedly positive, proactive twist.  If you've come here for another spittle-flecked cry of doom, you'll be sadly disappointed.  Cassandra's been carted off to get de-loused (though fear not, she'll probably be back next month).

Instead I'll be introducing you to a remarkably simple, statistically sound and highly profitable strategy which can not only help steer you towards long term investment success but has equal claim to be your best hope of avoiding investment disaster.  Sound too good to be true?  

Oh, ye of little faith.

Warren Buffett's Two Rules for 
Investment Success:

Rule no. 1:   Never lose money.
  Rule no. 2:   Never forget rule 1.

The simple rule-based strategy I'm going to outline is principally designed for those who are looking to build up a return over a decent amount of time - several years at least or, ideally, decades.  But it can also help anyone who is already invested in markets to know when 

  1. it's least risky and most advantageous to buy in 
  2. it's absolutely imperative to get out

It's possible to use the insights of this strategy whether your money is instantly available in a trading account or tied up in a pension.  It is a godsend for 'amateur' investors who have little or no time to follow the markets, yet it could also offer those hardened traders amongst us a thing or two: namely, the virtues of simplicity, the advantage of keeping a long-term perspective, and the joys of 
being able to sleep at night.

Unfortunately, it's not a get-rich-quick scheme. What it is is a get-rich-agonizingly-slow scheme which takes its signals not from any esoteric indicator or pundit or prognosticator, not from any human input which can so easily screw up, but from the movement of the market itself.


Well-trained financial advisors with letters after their name will tell you not to try to 'time' the market.  They will tell you to drip-feed your money in regularly because it's 'just not possible' to pick tops and bottoms with any consistency.

Complete cobblers.  Do you think Warren Buffett became the richest man in the world by 'drip-feeding' his money?  Folks, he buys low and sells high just like every other successful money manager in history. Everyone has a different way of doing it but if you don't time the market, even in the most basic sense, you just can't make money.  

The strategy I'm going to show you here is basic indeed, yet it has picked virtually every major top and every single major bottom in the last century and, what's more, can be confidently expected to carry on doing so.  You don't need any knowledge of finance whatsoever to make it work.  The signals are entirely automatic. Implementing it requires no more than ten minutes per month, plus, on those rare occasions when a signal is given, the inconvenience of making a call to your broker or pension provider.  

Yes, traditional financial advice can be helpful in many ways, especially if you have complex affairs, but beware: commission-based advice is compromised, always, by a fatal flaw -

  1. Financial advisors will give extremely persuasive reasons to stop you taking your money out of the market, even if it's the only sane course of action.  That's because they only get paid if you leave your money in.
  2. For the first time in half a century, the long-term market climate has changed - but even if your advisor believed that were true, for reason 1 he would probably never tell you.


It's just not fair, folks.  For a quarter of a century, putting your money in stocks was the equivalent of feeding a slot machine that always hit the jackpot.  Markets travelled an almost permanent upward path.  Yes, there came the occasional cloud of doubt, but those were soon blown away as stocks swept on into broad sunlit uplands. Then came 2000 and the dot-com crash.  Then came 2008.  Were these an inconvenient blip, or did something really change?

Let's look at the last century of returns in a bit more detail, courtesy of an excellent study from top technical analyst Martin Pring.

Source: Martin Pring, Pring Turner Capital Group

This is a composite of the major US S&P stock indexes from 1880 to today.  One look reveals a startlingly obvious pattern.  Strong bursts higher have alternated with regularly interspersed periods of consolidation, stagnation, or collapse.  During these times it was extremely difficult to make money in shares unless you were an expert stock-picker or could afford to sit through years of down markets.

Here's a look from a slightly different angle which makes this even clearer.

This time the composite index is adjusted for inflation.  As you can see, this view turns some periods of what appeared in the first chart to be consolidation into outright decline.  Pring also shows that these are drawn-out processes - 19, 20 and 16 years each, which suggests we may have at least 7 years more turmoil to go - and which have historically involved at least 4 recessions.  So far we've had 2 (just 1 in the UK).

The bottom half of the above chart shows perhaps the most widely-accepted measure of share price valuation, the Shiller price-earnings ratio.  This averages stock valuations over the previous ten years to smooth out fluctuations and has pinpointed long-term market lows only when the ratio dips below 8.  Today, that measure stands at over 20.  

Look at it yet another way.  

Four great peaks over the past century have led to big moves down of 25% or more then strong rallies of 25% or more until, after a multi-year sequence of these swings, a new long-term bull market begins.  This sequence of 25% or greater moves numbered at least 5 for all three previous long-term bear markets.  We are currently in the 4th (up) swing of 25% or greater since the top in 2000, suggesting the likelihood of at least one more big drop. 

So, despite this being by common consent the greatest crisis since the Great Depression, you'd have to believe the market could recover far quicker than even the mildest of previous crises to be happy investing new funds now.  In fact all in all, to trust that markets will keep on pushing higher after a 70% rally from the lows of March 2009 would require you to pretty much dismiss 130 years of stock market history.

Okay, let's say you're prepared to take this on board; that you'consider becoming more active than perhaps you have been in protecting your investments - how do you go about it?  Is it genuinely possible to identify these major down moves before they cripple your investment account?  Can you consistently get out at the top - and then coolly buy back in at the bottom?  

Let's see.


One of the reasons Yale and Harvard are, well, Yale and Harvard, is that they've been extraordinarily good over the decades at making money through their endowment funds.  In fact, these two institutions' endowments have outperformed the benchmark S&P500 index by around 4% per year over the past 25 years, making average annual returns of 15% - 16%.  Only a tiny handful of money managers who run publicly-accessible funds can remotely compare.  

Compounded over time, this kind of performance will double your money every five years.  The impact over a working lifetime is truly dramatic.  

Indeed the power of compounding could have bagged you returns of over 600,000% - if you'd had the presence of mind to put a dollar in stocks in 1801 and collected it 200 years later!  You shouldn't have to live quite that long to build up a decent retirement pot, but if you want to retire comfortably you'll still need to harness the power of compound returns.  

Now, these endowments have access to various instruments (eg. hedge funds, private equity groups) which few ordinary investors can get near, so precisely replicating their level of success is difficult.  But, according to research published in a 2006 paper by equity analyst and investment manager Mebane Faber, achieving something close is not impossible.

Last year he published an updated and fleshed-out version of this research in a book called 'The Ivy Portfolio - How to invest like the top endowments and avoid bear markets'.*  Its simplified no-nonsense approach distills investing down to the two elements which haveindisputably over time, been shown to work: diversification and trend-following.

* In case you're wondering, I have no interest whatsoever in this publication nor any connection with Mr Faber.  I'm making this recommendation purely on merit.


Diversification - holding a number of investments which are deliberately selected to deliver returns at different times in differing economic conditions - is, in one of Buffett's famous sayings, 'a hedge against ignorance'.

It's a way to win even when you don't fully understand what's going on in the markets.  Stocks, bonds and commodities, for instance, have all performed well historically though generally speaking at different times.  So by holding all three simultaneously, the theory goes, you should be able to make steady and consistent gains (and limited losses) because at least one of your holdings is outperforming even while the others lag. When market conditions change, your top performer may poop out but one of the laggards will take off, ensuring your whole portfolio doesn't get mashed.  

Bonds (red) were your only protection against 
plunging stock markets in 2008

By effective diversification, then, the huge peaks and troughs of market life get smoothed out into (what one hopes is) a nice gentle upward curve on the chart of your quarterly statement.  Mebane Faber's analysis of the endowment portfolios reduces the number of essential components to five:

  • US stocks
  • International stocks
  • International commodities
  • US Property
  • US Govt. Bonds

British investors should simply substitute UK for US holdings.  You can add other components if you like but an equal 20% weighting of each of these five in your portfolio is a good basic starting point (I'll be suggesting some important tweaks in further updates).  

If you know little or nothing about individual stocks don't worry one bit, you don't have to.  Each category can be represented by a low-cost ETF (exchange-traded fund), a mutual fund or a unit trust purchased through your broker which can (and ideally should) be held in your tax-free investment account.  

They can also be bought within a UK self-invested personal pension or a US IRA or 401k.  If your investments are managed opaquely by a pension provider, they should be automatically diversifying into different asset classes as you feed money in, according to the specifications on your personal risk profile.  More on this later.


For decades, diversification did exactly what it said on the tin: it reduced the wild swings which are the investor's occupational hazard and enabled those who wanted to avoid the pitfalls of market timing to let their money take care of itself.

Then came 2008.

As banks, hedge funds and individual investors raced for the exits, they sold anything that wasn't nailed down in a dash for pure cash.  Just about the only investments that rose in price were the $US dollar and US Treasuries (government bonds).  

Property, stocks, commodities all tanked then rallied together as investors rushed into bonds (red) 

The Yale and Harvard endowments were badly hit and lost around 30% of their value, which was unheard of (though still better than the 60% haircut taken by the stock market).  In the extraordinary rebound since March of '09, assets have remained tightly correlated, with stocks, bonds, property and commodities rising and falling virtually as one.

Even the best diversified investors could be in deep doo-doo were markets to be hit by another shock.  Recently, the former investment manager of Harvard Mohammed El-Erian has himself admitted that, while diversification is essential to protect against risk, in the current environment it is not enough. That's where this strategy delivers its master-stroke.


Take a good look at this monthly chart of the US S&P500 index over the past 15 years.

The Keep-It-Simple-Stupid timing strategy

Each bar shows the index's price range and where it closed on the last day of the month.  Overlaid is a 10-month simple moving average.  You buy when the index closes above the moving average, you sell when it closes below.  

That's it.

No judgement is required, no understanding of economics, finance or markets.  Just the discipline to buy and sell according to these simple signals, freely available on a number of charting websites (I'll link you up to one at the end of this post).

Following the strategy is hardly onerous either.  Over the past 15 years you would need to have made precisely 15 calls to your broker to either buy or sell.  There are occasional 'whipsaws', where you sell after a bad month then have to buy back almost immediately as the market zooms back up, sacrificing profit in the process.  But this is the cost of being able to sleep at night.  This is the price you pay for avoiding disaster.  

For sure, the past ten years has made this system look amazing, but what about prior decades?  Is the above chart selling you a bill of goods?  Here are the returns from the same system over the last 40 years.  It compares the results of buying a fund representing every stock in the S&P500 index and following the timing signals as illustrated above, compared to simply buying and holding the same fund through thick and thin:

Source: M. Faber, 'A quantitative approach 
to tactical asset allocation', 2008 

The system kept pace with the index well until the dot-com mania made anything but hanging-on-to-that-rocket-to-the-bitter-end a losing strategy.  But since then the system has triumphed, gaining substantially over the past decade while buy-and-hold investors have rocked and rolled and watched their retirement accounts languish and wither.  

Finally, here is the whole enchilada - a century of stock market timing using this simplest of all possible strategies:

Is it perfect?  Of course not.  Is it an improvement?  
You bet.


All we need to do now is combine the diversification and timing strategies I've outlined here into a coherent system which can be easily followed.

First, select the different asset classes and investment vehicles you want to hold (in later updates I'll be making a number of suggestions); second, chart them on a monthly basis using the free services I'll link you to; third, buy each with a lump sum when they next cross above their individual 10-month moving averages and begin to follow the strategy.  

This discipline of buying and selling is very important to its success: you need to check the charts religiously once a month, then on the very next trading day call your broker or pension provider.  You have to ignore your emotions, bottle your opinions and do as you're told by the system.  Tough, huh?

Here are the results of following the other asset classes in the same way.  First, US government bonds, using the 10yr Treasury note as an index:

Source: M. Faber, 'A quantitative approach 
to tactical asset allocation', 2008 

Property, following the US NAREIT index:

Commodities via the Goldman Sachs Commodity Index:

International (non-US) stocks, using the MSCI EAFE Index:

And finally, once you combine the returns of all these:

Since this chart was drawn in late 2008 the system has continued to perform superbly, staying out of the carnage until rejoining the party in stages through 2009.  

The strategy reduces overall volatility markedly, making the drawdowns (maximum losses at any one time) far less severe by jumping out of the market when danger is greatest.  It then hops back in when the storm has passed and hugs each index closely as it rises.  

Can future returns be guaranteed?  No strategy can ever claim that, no matter how long it has been successful, partly because if too many start using that same system its effectiveness will tend to decrease.  

But this strategy has only been in publication for a year and garnered little publicity (probably because it's just not 'sexy' enough).  And because signals are given directly by price action and not by any external indicator, the timing component should continue to work well.  Over time the recent tight correlations between different types of assets will eventually loosen and we'll see diversification once again reclaim its role as the long-term investor's greatest friend.

In any case, if the concern is that a currently-successful strategy may not provide guaranteed future returns, are we implying that the alternative - having no clear strategy, or a losing strategy - does carry some kind of guarantee?


I've known about this approach for some time and had initially dismissed it for my own purposes as being too, well, simple.  After all, a financial wiz is supposed to have all sorts of sophisticated tricks up his sleeve to work out how to buy low and sell high - why would he need something as child-proof as this?

Total strategy returns versus 
buy-and-hold 1973-2008
But the more I've considered it, the more I like it.  Essentially, it's a strategy for life.  It controls your dumbest trading instincts, the ones which make you buy near the top and sell at the bottom, by giving unambiguous signals which you can be confident will keep you from investment disaster.  

The diversification requirement cannot hurt and in the long run is bound to help and smooth one's returns.  The timing method is proven to perform consistently over more than 100 years of data.  Drawdowns, those sudden sickening plunges, are impressively minimized, reducing further any temptation to sell in panic.  It's not remotely taxing of one's time or brain power.  It allows a person to sleep at night.  And by comfortably beating a buy-and-hold strategy decade after decade, it genuinely delivers.

In short, as long as one has a multi-year and preferably multi-decade time horizon, it's the simplest, smartest, most practical answer to that eternal investment question - how can I ensure I'll have a decent income when I retire? 

And so, sacrificing street-cred no doubt, I'll shortly be introducing this into my overall investment plan.  It will form the backbone of my long-term strategy, and I'll automatically follow these timing signals as long as my other reliable timing methods aren't telling me, en masse, to do the exact opposite.  

Over the next month or so I'll be introducing a number of significant tweaks to take account not just of the current tight correlations between asset classes, but of my recent research on last year's extremely rare momentum in stocks.  I'll present these to you in blog updates over the next few weeks.


Here, for starters, are live links to charts of the indexes referred to in Faber's original study:

Note that you can't buy these directly - what you'd buy are products which closely track these indexes, either ETFs which are low-cost and swiftly traded or US mutual funds/ UK unit trusts which are generally more costly and can't be bought or sold quite so easily.  Lists of and guides to all these are provided by most major brokers, eg. TD Ameritrade, E-Trade, Charles Schwab in the US and Hargreaves Lansdown,  Bestinvest, Selftrade & Killik in the UK.


The possibilities for running this strategy within a company or personal pension will vary depending on your provider's rules and whether you are able to specify your own investments.  

But even if you have little control over the specifics, most providers enable you to, at the very least, switch between 'higher-risk' and 'lower-risk' assets as they themselves define them.  Higher-risk would certainly include a major-weighting of stocks, while lower-risk would have you much more tilted towards government bonds and cash.

If these were the limits of my access, I'd switch between the two levels of risks as follows: 

  • If US bonds are on a BUY signal
  • And US stocks, plus either real estate or commodities, are on a SELL signal

...I'd switch to the lowest possible risk category available.  Any other configuration would suggest being invested according to my original arrangements. 

The alternative to this kind of make-do strategy for UK investors is to transfer your current arrangements into a SIPP - a Self-invested Personal Pension, in which you have the freedom to choose whichever investment vehicles you prefer.  Here's a guide to doing just that from UK broker Hargreaves Lansdown.


That's it for now folks.  We're in a work-in-progress, and I'll be back to update and finalize the strategy over upcoming weeks along with, as ever, nuggets on the property market, commodities, the price of eggs etc. etc. which may either feed your prejudices or give them a good ol' clip round the ear.

My next monthly post will hit your screens sooner than you think - Sunday 5th September - by which time we'll hopefully be easing into an Indian summer.  Bask, friends, bask... and have a great month!