Yesterday I mentioned that some of last year’s dog stocks — Telstra for example — could become the winners of FY19.
However, I said that I wouldn’t be buying yet. The problem is that the share prices in question were still in a downtrend. Buying into a downtrend is a low probability play, no matter how appealing the value, or how good the fundamental ‘story’.
How can you improve your investment odds?
Yesterday provided another example of how following this rule can save you. Sigma Healthcare Ltd [ASX:SIG] dropped a whopping 40% in a single session. While no one can predict such a significant fall, you can improve your odds of avoiding a bomb like this going off in your portfolio.
Take a look at the chart below. It shows Sigma’s share price over the past two years. As you can see, it’s been trending lower for most of that time. There is just no reason to buy this stock, regardless of the fundamental picture. 10 seconds of ‘analysis’ tells you to stay away.
[Click to open new window]
And you stay away not just because there’s a chance of a huge one day decline. You stay away because probability favours that a prevailing trend will continue. And to state the obvious, it will continue until it exhausts itself.
In the case of individual stocks, trends continue until the supply/demand equation (of shares traded) first stabilises, and then swings around in favour of demand, which starts to push the share price higher.
This simply means that enough holders stop selling, while for whatever reason (good value, improving earnings outlook) new buyers come in an increase demand for stock.
Apart from a brief period at the end of 2017, this never looked like happening for Sigma. So you would’ve stayed away and avoided yesterday’s explosion.
This analysis extends to stock market indices too. By looking at an index you get a sense of whether the overall vibe is bullish (index trending higher), bearish (index trending lower) or going nowhere (index moving sideways…not trending).
The S&P 500, below, is a good example. If you look at the moving averages (the yellow and blue lines) you would say the US stock market is still in an uptrend and therefore still bullish. But unless the index remains above the MAs and starts to push higher soon, then it will quickly change into a trendless market.
[Click to open new window]
A decline below the February and early April lows will signal a new downtrend and bear market. But we’re some way from that point. Right now, the odds are on a rising to sideways moving market.
What makes the analysis tricky at this point is that we’re already at a historically stretched part of the cycle. This bull market is the second longest on record. The chances of it powering on from here are much lower than they would be if this situation occurred, say, five years ago.
And because we’re at this part of the cycle, you’ve got the US Federal Reserve increasing rates at a potentially faster pace. If they go too far, it won’t be good for the stock market. And there is the classic end of cycle reaction in the form of an escalating trade war to consider.
So you need to be cautious here. My view is that we could be at a major turning point for US stocks. But my view is just one amongst millions. It doesn’t mean anything. Let the market tell you which way things are going to go.
The Aussie stock market tells a different story though. The ASX 200 (see below) has surged higher since bottoming in April. It is trading around the highest levels since the GFC back in 2008.
[Click to open new window]
Fear versus greed in the market?
Who would’ve thought the index would make new decade highs at the same time as the housing market starts to crack lower? The market always does the unexpectedly, which is why it’s best not to hold your opinions too close. Chances are they will be wrong.
For example, here’s an opinion the market doesn’t agree with. From the Financial Review:
‘Top economists are turning more bearish on the housing market at the same time as fund managers fear house price declines could trigger a “nasty cycle” in the economy and more downside for the Australian dollar.’
Whoever is experiencing ‘fear’ right now, it’s not showing up in the buying and selling decisions of the market. Why? The next sentence in the article gives you the answer:
‘The more downbeat expectations on housing emerged as economists scaled back their expectations for the first interest rate hike from the Reserve Bank of Australia since it cut rates to 1.5 per cent in August 2016.’
The market has priced in a prolonged low interest rate environment and it’s good for stock prices. Moreover, it doesn’t see property price declines as being severe enough to hurt bank balance sheets, so you’re seeing bank shares prices rally even as ‘top economists’ think the housing market will get worse.
In fact, I would argue that the worst of the house price falls are probably over. That’s what the market is saying, anyway.
The bottom line? Listen to the market. Not ‘top economists’ or those with strongly held opinions. The stronger the opinion, the more emotional the reason for holding it. That’s always dangerous in a world as complex as the one you are living (and investing) in today.
Editor, Crisis & Opportunity