September 21, 2010
The Trouble with Fibonacci Reversals
The Investment View from Prescott, Arizona
Since December 15th of last year I have written 4 times about the Fibonacci effect the market has been displaying. This is the 5th as the phenomenon keeps recurring.
Leonardo Fibonacci was the 12th Century Italian mathematician whose discoveries inspired many of Leonardo DaVinci’s works and inventions. One of Fibonacci’s discoveries was that trends in nature tend to repeat themselves mathematically.
Stock investing is practiced by us humans, so we are influenced by the same natural trends Fibonacci observed. His insights show up in the size of the waves in the price graphs as the stock market goes up and down. Another is the time sequence between the peaks and troughs of waves. Both follow Fibonacci sequences more often than not.
This current situation is a good example. The stock market peak of October 9, 2007 was at 1065 for the S&P 500**. The bottom on March 9, 2009 was at 676. The midpoint between the high and the low is 1120 for the S&P 500**.
This is what I call a 50% retracement of the 2007-09 losses in the market, and ½ is a key Fibonacci relationship.
In November, 2009 the S&P 500** began acting like it had run into a glass ceiling at 1,115. That month alone it reached that level 4 times, only to promptly fall back each time.
Since this can be an imprecise business, I consider any reversal within 1% of the 1120 level to be a Fibonacci reversal. 1115 counts. After 800 years, I’d say we can give old Leonardo that much of a break.
The S&P 500** closed this past Friday (September 17th) at 1125. You may cue the Twilight Zone music.
The Fibonacci retracement level I mentioned has been the point at which the stock market reversed itself at least 12 times in the past year, and perhaps as many as 27 times if we count all reversals occurring between 1103 and 1131 on the S&P 500 Index**.
Clearly Fibonnaci was onto something and only time will tell when we will break out of the 1100-1130 trading range that has been limiting the stock market for almost a year now.
As I frequently say, I don’t predict the future, but I know what is most likely to happen, and I hope I will recognize it when I see it. A breakout from the Fibonacci bound price range is one of the things I am watching for from the stock market.
As a practical matter we investors have to deal with the implications of these repeated Fibonacci reversals.
When the market turns down, anyone who has been invested with the original trend has two choices, either change the investments to match the new trend or sit tight with losing investments and hope the market turns back up. When it comes to investing, I consider hope to be a four letter word.
I normally change the investments to match the current trend, because all large declines begin as small declines and no one really knows in advance if or when a trend will change. For this reason I respect even small declines.
The problem for me comes when the trend changes back to the original direction. I have to move my investments yet again, and often end up with an unprofitable trade to show for my efforts. These short, losing trades are called “whip saws”.
Occasionally we can see several whip saws in a row before a longer term trend reasserts itself, and each whip saw can create a losing trade, perhaps several in a diversified portfolio like I maintain for my clients.
The problem is that all big losses start out as small losses, and unless you have the discipline to sell early in a decline you risk taking the big hit.
Small losses caused by whip saws are unavoidable if we want to avoid getting caught in a big decline – the kind that can change retirement plans and lifestyles. My style of selling out early in a decline and risking small whipsaws is the price we pay for the risk reduction which is my specialty – the cost of “catastrophic decline insurance”, so-to-speak.
Better Times Coming for the Stock Market
I have mentioned in my previous newsletters that there are serious headwinds for the stock market including a weak economy, weak demand for goods, services and even loans, as well as stiffening competition from abroad and still-unfolding debt crises in Europe.
Despite improving conditions in the stock market, it is difficult for me to say that the economic slowdown here in the U.S. that began this summer had ended.
Because of all of this, I have been cautioning that conservative investors should not be taking on much risk right now, meaning don’t really load up on stocks quite yet.
However, there is good news in the market cycles, too.
The 4-year presidential cycle is one of the most reliable in the business. Normally it brings a low point in the second year of the cycle (2010). Since we are not yet at the end of 2010, a possible future low demands some respect.
However, once that low point of the year is in, the investment outlook gets much better.
If we go back 100 years and look at the average of each 4-year investment cycle, the stock market, between the low point of the second year and the high point of the third year produces an average gain that is well into double digits and well worth the wait on the investor’s part.
If the low of the year is already behind us this is very good news, indeed. If not, we need to preserve our investment capital until we know the low for the year has been recorded and the market is likely to begin its upward run into year 3 of the election cycle.
The first task is to break out of the trading range that has held the market back for a year. The market has improved dramatically over the past 3 weeks, but has still failed to break out of its trading range. If there is another dip before we do break out to the upside, we must make sure we conserve as much of our investment capital as possible.
Then we will be in a great position to make some good money in the stock market. Stay tuned, I expect things to start getting fun when the market finally breaks above 1131 and stays there.
What We Were Saying a Year Ago
Financial plans based upon MPT [Modern Portfolio Theory] evaluate your comfort with risk and based upon long-term returns declare “this is the best combination of investments for you. Buy these couple of funds and that is all you have to do. The computer says so.”
Ironically this “modern” theory was developed in 1952 and while it may have worked well back then it has been a disaster for the past 10 years or so.
But old habits are hard to break and financial plans based upon MPT are such great sales tools that brokers and planners still offer them up even though investors who have followed them have taken staggering losses.
The flaw is that MPT based plans lack diversification by strategy. They totally ignore the fact that the great American investment creed of “Buy low, Sell high” has two parts. MPT makes no provision for selling. Ever!
Back to the present: Almost all investments start out as good investments. The problem comes when market conditions change and your investment cannot perform well in the new market environment.
I always recommend that clients include in their investment plans strategies that can Adapt to Changing Markets®. This means an active component that can identify investments no longer in sync with current market conditions and tell you when to sell them to avoid large losses.
If your investment plans do not have clearly defined strategies to protect your investments, perhaps we should talk about how to correct that for you. Call the
office at 778-4000 to schedule a free consultation.
Q: What kind of coat can only be put on when wet?
A: A coat of paint
What’s Going On In Your Portfolio?
I got a nice compliment when a Ceros representative was in the office on Wednesday, September 15th, training us on new trading software.
We used our Balanced* portfolio to program the new system. At that time the Balanced* model held 11 different investments, plus a money market, and all 11 had green numbers in the gain/loss column! As users of our online system know, this means they all had gains.
This man’s job is to work with money managers all over the country. He sees a lot in his travels. I wish you all could have been there when he stopped what he was doing to comment on how rare it was to see a money manager without a single losing investment. I was flattered.
I certainly am not able to have all winners all the time, but it was nice to get noticed by someone with an industry-wide view.
And our balanced strategy is made up of 50% Careful Growth* and 50% Flexible Income*, so this means that every investment in each strategic model is working at the moment. Nice!
The Flexible Income* model holds a currency fund, gold (essentially another currency), preferred stocks held for their 6% dividends, along with two diversified bond funds, also paying high dividends.
Careful Growth* accounts also hold gold and preferred stocks, but also include 15% in some US growth stocks and 15% in Emerging Markets country funds representing Chile, Indonesia and Malaysia. All are doing well as of this writing (Sunday, September 19th)
Help the Shriners Help the Kids
One of my community activities is to serve on the board of the Yavapai Shrine Club. A Shine slogan is “Have fun helping kids.”
The Shriners may be best known for Circuses and clowns who race around parades in little go-carts or scooters. The serious side of their work is to support the 19 Shriner’s Children’s hospitals around the country that specialize in rehabilitating young burn victims and crippled children.
The Shriner’s Hospitals are free to any child who needs them.
The local clubs raise money to pay for the transportation of kids and their families to the appropriate Shriner’s Hospital.
Our local club is holding a raffle in which you could win cash in the amounts of $5,000, $3,000, $1,000 or $500. Only 250 tickets will be sold, and the drawing will be held this Saturday, September 25, 2010.
Tickets are $100, and I have a few left at the office. Please stop by and pick up one (or two) if you would like to support this worthy cause.
I would really appreciate it, and so would our kids.
Call Us if Things Change
When you became a client, my investment recommendations are based upon your concerns and financial circumstances at that time. If your circumstances, or your degree of concern about financial matters changes, please let me know as soon as possible so that we can address your concerns and make sure the strategies used in your accounts are appropriate for you.
The one thing money is good for is not having to worry about money. If you are worried about yours, please call today.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.