“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”
Charles Dickens, A Tale of Two Cities
These are indeed interesting times, most notably due south of us in the USA. The government is playing it’s usual game: creating an ‘artificial’ crisis, building fear within the general populace, finding solutions at the final hour, then positioning itself for vote buying by the next election. Same old, same old.
Markets and politics are like that. Perhaps a good theme song for the cycles that predictably repeat is Joni Mitchell’s “The Circle Game”. Despite the fact that the world evolves around patterns, we all want to believe that this time is different and lose portions of our wealth in the process. As a friend of mine once quipped: finance is defined as the transfer of wealth to the shrewd and corrupt, from the rest of us.
In an effort to benefit from the predictable patterns markets take, there are countless processes adopted to take advantage of the inevitable. Everyone seems to have their own system: technical analysis, fundamental analysis, the direction of the VIX and the yield curve, Dow Jones transportation average direction, courier company volumes, insider selling behaviour, the farmer’s almanac, consumer sentiment, GDP thresholds, the outcome of the Super Bowl, hedge fund activity (ie: Soros waving bye-bye), option market trends (too much Put buying), shoe-shine boy recommendations, trading momentum and other general market indicator(s) analysis. And that’s the short list.
Sometimes you can make an indicator or system say anything that you want it to say. This is one reason why these are indeed the best of times, and the worst of times. The sell side continues to see things via rose-coloured glasses (keep ‘em emotional, keep ‘em trading), while the naysayers are forecasting either another recession or an ‘inevitable’ US default, leading to a market drop of potentially 40% or so. Some people believe the current market is almost as risky as Montreal’s infrastructure. Alas, someone is going to be right, while another is going to be wrong. Funny how life predictably repeats itself – or as Mark Twain observed: history does indeed rhyme.
While there may be countless models used to predict the future direction of markets, few deal with economic signals and indicators in an effort to conduct a risk assessment. That is the focus of Conquering The Divide (CTD). In 124 pages, Cornehlsen and Carr (C&C) aim to provide a model that aids in the reduction of risk of stock market investments. They postulate that although the stock market does predict the future of the economy, “some economic indicators do the opposite and forecast directional moves in the stock market.” We all know that getting into the market can be tricky due to fear and emotion, but the authors are also concerned about exiting the market before significant declines occur…and they will. Buy and hold investors, take note.
C&C begin their book with a look at investor behaviour and the reluctance of investors to embrace economic data (ie: fear of numbers). The media provide us with countless economic numbers (often referred to as noise), while market pundits try to make sense of what the data actually means. That is why the authors work toward a simplified model using economic indicators that can be more easily understood. A key message is that risk is constantly changing, and it’s the assessment of that risk that leads to sound decision making around the buying and selling of stocks. In other words, avoiding that risk! The business cycle does exist, and like the change in seasons, this cycle inevitably ends with a thud. The goal for the informed and involved investor, is to don the parachute before the pending crash.
Despite the fact that many of us find economics to be too dry a subject, the authors work to show us that an understanding of this social science can help us to identify and quantify the attributes impacting a company’s revenue, earnings, and valuation. Although valuations are supposed to reflect future earnings expectations (that’s the theory), the reality is that the market can/is also be driven by good old human emotion. Adhering to a cold, concrete process aids in removing that emotional factor. We all know markets can remain irrational longer than we can remain solvent ! The goal of the authors is to convince us to use select data to assess the risk – not our gut. In other words, understand that emotions and fear can cloud our judgement if we don’t have an objective process to overcome those issues. I should add that our success is not only defined as knowing when to leave the party, but also when to sit tight and enjoy the ride.
Logically, when we understand that the economy is weakening, this usually leads to declining investor confidence. And as the authors note, “…the market doesn’t try to decide who is right or wrong, the market simply decides who makes money.” Hence, they emphasize that investors should put as much effort in assessing the direction of the market (using an economics-based model), as they do in evaluating each individual stock holding. In other words, you have to do additional HOMEWORK.
The whole point of the process as outlined by C&C, is not to define the direction of the economy as much as its IMPACT on the stock market, while pin-pointing the specific phase of the current business cycle. And recognize, for example, that an economic slowdown is easier to predict using a model that incorporates a combination of specific indicators. The authors are the first to admit that all indicators can provide false indications at times – which is why they promote the idea of using multiple, select indicators to create redundancy in assessing the state of the economy. Multiple indicators help to identify “incremental improvements or deteriorating conditions in diagnosing the economy”.
One indicator that has been in the limelight recently, is consumer spending. As the centre of economic activity, C&C emphasize that this is also a key driver for earnings growth and that earnings (are supposed to) drive stock prices. (To put this into context, market watchers are currently baffled by the opposing forces of increased earnings versus high unemployment). If consumers base many of their spending decisions on the future direction of interest rates (yet another very hot topic currently in North America), this can be yet another valuable variable within an analytical model.
There are several other potential market indicators (categorized as leading and lagging – some for bull markets, others for the bear), but the important points are where they diverge. The authors build their model in an effort to fortell those turning points, using what they define as reliable leading indicators. Not exactly a formula for a pure buy and hold investor! They make it quite clear that : “all stocks need to be evaluated in light of current market conditions” Just look at the latest drubbing of the world’s most durable industrial stocks !
In the final chapters of CTD, the authors select their three primary indicators (sorry, for this you’ll need to read the book!) and describe the parameters in using each of them. The goal is to make the process efficient and simple to follow – including quick monthly reviews. They provide the reader with some historical context and demonstrate that their model produces far better results than simply buying and holding. The emphasis, again, is the need for you to do your own homework and think for yourself, rather than depending on potentially-biased media reports.
What I can tell you, is that one of their indicators just hit a critical threshold, one factor causing a period of significant decline in the DOW.
By combining the three primary indicators, the authors build their composite model. The model, which again is designed to identify risk, is at its best in helping the investor to avoid bear markets. As noted above, the intent of using multiple indicators in the model, is to reduce the likelihood of false signals.
Finally, Cornehlsen and Carr outline the use of a detailed monthly report defined as their Economic Market Indicator. They combine the output of this tool with the tried-and-true elements of technical analysis on the investments they have on their watch list.
As mentioned previously, the markets do move in a predictable pattern. But the successful investor understands that it’s the ability to identify the conditions that will lead to the timing of the changes.
The authors do a convincing job of showing us how to use available tools and economic data – along with some effort – to identify the signals that can help us to recognize when risk is low, and to some, more importantly, when risk is high. All we have to do, is get involved on a regular basis ! True, it is a lot easier to simply buy a mutual fund and spend more time vegetating in front of social media or
Dr. Phil. But CTD, coupled some additional homework, can serve as a potential addition in your arsenal of tools to improve your return on investment.