The Problem Most Investors Face Using History to Predict the Stock Market

Good information is critically important to making decisions about your investing. The problem is, there is so much "noise" out there that it can be difficult to focus on the few things that will be the most helpful to you. So the default setting for most investors is to look at history.

The history of the market: what happened last year, the last 10 years. The history of the stock you're considering buying: the most recent quarterly earnings, last year's results, how much it's up (or down) in the past five years.

Unfortunately, that type of history will not make you a better investor. How many times have we been told that "past results do not guarantee future performance"?

This is why at The Market Forecast we ignore almost all news--it concerns itself with what has already happened. And it's not useful, because we can't change it or act on it. We want to know what's going to happen next. Read the news for entertainment, not stock market prediction.

Jason Zweig of The Wall Street Journal reveals one of the greatest pitfalls of relying on history: What if the accepted history is just plain wrong?

He writes that even though U.S. stocks as a whole have underperformed the long bond for the past 5, 10, 15, 20 and 25 years,

"Still, brokers and financial planners keep reminding us, there's almost never been a 30-year period since 1802 when stocks have underperformed bonds.

"These true believers rely on the gospel of 'Stocks for the Long Run', the book by finance professor Jeremy Siegel of the Wharton School at the University of Pennsylvania that was first published in 1994.

"Using data assembled by other scholars, Prof. Siegel extended the history of U.S. stock returns all the way back to 1802. He came to two conclusions that became articles of faith to millions of investors: Ever since Thomas Jefferson was in the White House, stocks have generated a 'remarkably constant' average return of nearly 7% a year after inflation. (Adding inflation at 3% yields the commonly cited 10% annual stock return.) And, declared Prof. Siegel, 'the risks of holding stocks decrease over time'."

"There is just one problem with tracing stock performance all the way back to 1802: It isn't really valid...The 1802-to-1870 stock indexes are rotten with methodological flaws.

"Another emperor of the late bull market, it seems, has turned out to have no clothes."

Read the entire article at

http://finance.yahoo.com/news/Does-StockMarket-Data-Really-wallstreet-2749436021.html?x=0&.v=4

So, which history do we use?

Cycle analysis is the only tool we have found to be accurate in predicting the markets. Then we confirm with a handful of useful technical indicators, including the 5-, 30- and 50-day moving averages, along with volume. And we employ our crossovers for intraday and short-term trades.

That's it. Everything else is just noise, or entertainment.

Only 25%?

Earlier we wrote that only 25% of stocks outperformed the market.  William J. Bernstein writing in Money Magazine provides further information:

"In fact, researchers at the investment management firm Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago's CRSP total equity market database (see the chart).

"As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses of around 2% over the past 29 years."

Read the entire article here:

http://money.cnn.com/2009/05/09/magazines/moneymag/stock-strategies.moneymag/index.htm

A Quick Summary of the Year to Date

From Steve's Commentary for July 6 at The Market Forecast:

"[W]e had two incredibly sloped intermediate moves during our first six months of trading this year. If you followed only the intermediate cycle and just played it twice, using the DXD in the January-February decline, you gained about 46%. Since the March 6th lows, the DDM rose to a high with gains of 70%. That's a whopping 116% so far this year. If you add to that the ability to trade many of the shorter term swings in between those moves, the returns go much higher.

"But don't worry if all the news kept you out too long, or you struggled with taking profits too early, or you are just learning how to play both sides of the market. The important thing for everyone here, is that you didn't get slaughtered by the bear side of the markets as did just about everyone else. You've managed to be profitable during an historic time when most investors were left holding the bag at the top, and who are still down some 40% from where they were in October 2007 (even after the recent recovery rally).

"Best of all, there is plenty of big swing action remaining and our cycle work should keep us on the right side so we can do it all again!"

Exactly what is Steve talking about?  

First, our cycle charts tell us what is coming next. They are great for predicting the market.

Second, we use simple technical indicators to confirm market moves. We'll include a 5, 30 and 50 day moving average to define key support and resistance levels. Throw in Steve's favorite short-term crossover, along with a couple of tools he has refined, for intraday trading confirmations.

And third, we use Exchange Traded Funds (ETFs) to take advantage of moves up and down. Why ETFs? To keep it simple.  

Many investors are spending valuable time trying to identify good stocks that will outperform the market. It's time-consuming work.  

The fact is, research shows that only 25% of stocks beat the market on average. Even fewer are real "home runs". And a full 75% of stocks fail to keep up with the market. We don't like those odds.

Think about those facts. If a rising market lifts good stocks and the poor ones fail to keep pace, why waste time looking for the home run stocks? Simply trade the market that lifts those stocks!  

If you want to outperform a bullish move, trade the "double-beta" ETF tied to that index. Double-beta shares are designed to move up twice as fast as the underlying index. Is the market turning, heading down? Trade the double-beta ETF intended to move up twice as fast as its underlying index is falling.

We'd rather identify market direction, correctly forecast reversals and re-entry points for profitable trades, and then trade the entire index with the corresponding ETF.

We recommend the DDM, QLD, SSO, FAS for bullish markets moving up. The first three are double-beta shares tied to the Dow, the NASDAQ, and the S&P 500, respectively. As for the FAS, that one is a triple-beta ETF intended to move up three times as fast as the Russell 1000 Financial Index.

We recommend the DXD, QID, SDS, FAZ for bearish markets moving down.  Like their counterparts above, the first three are double-beta shares tied to the Dow, the NASDAQ, and the S&P 500, respectively. The key difference is that they are designed to move up when the underlying index moves down. The FAZ is a triple-beta ETF intended to move up three times as fast as the Russell 1000 Financial Index is moving down.

Caution:  These ETFs are not "buy-and-hold" ETFs.  They are intended for trading.  Learn to do it right and you should see great results.

Remember to paper trade any new strategy or tools to become familiar with them and ensure you are trading profitably.

Markets Bounce Back in Q2

The market has posted its best quarter since the fourth quarter of 2003.  The Dow Jones Industrial Average gained 838.08 points during the last three months to its June 30 closing of 8447, up 11% from April 1.  And while the market is still down 3.8% year-to-date, it has advanced 29% from the 12-year low hit on March 9. 

But that's only part of the story for the second quarter of 2009.  Trading the DDM, ProShares' double-beta Dow tracking stock, and using The Market Forecast, we are up 58% since our cluster low in early March.

The S&P 500 was up 15% during the second quarter.  The NASDAQ was up more than 19%.    

So what's the performance of the SSO, ProShares' double-beta S&P 500 tracking stock?  Up about 76% from the cluster low on The Market Forecast Chart.  

And the QLD, ProShares' double-beta NASDAQ tracking stock, was up over 85% since our cluster low in early March. It's been an exciting time to be in the market.

Just as important, markets don't have to move up--we can take profits in downturns.  We look for continued opportunities to profit in the months ahead.

On days like today, when short term cycles are in the upper reversal zone, and the market has been rising for the past several days, keep an eye on the resistance points - which in this case is the 30 DMA for the Dow.

It ran smack into that average in the first hour of trade and reversed downward.

You'll see the break below the 8/8 crossover average on the 15 and 30 minute charts when that happens, and that will be a decent entry into the DXD for an intra-day or longer - inverse Dow play. Today it added nearly a buck within an hour of that event.

Steve

We keep seeing financial writers express their "Aha" moments in major publications. Writing under the headline "Buy-and-Hold Stock Strategy Can Be a Big Loser in a Bear Market", Matt Krantz of USA Today says:

"Buy shares of good companies and hang on. That's the way millions of investors have been trained to almost religiously invest for the long haul. Even Warren Buffett likes to say his favorite holding period is forever. But this seemingly common-sense approach, which has worked remarkably well over the decades for patient investors, proved extremely treacherous during the bear market. Investors holding onto some well-known stocks saying "they will come back" often found themselves holding onto stocks with next to no value...

"The market's vicious kicking the life out of stocks has been a brutal wake-up call for investors who long held out faith that holding on is the only way to go."

Read the entire article at

http://www.usatoday.com/money/perfi/stocks/2009-06-28-buy-and-hold-stock-strategy-investing_N.htm

An Interesting Take on Investing

This is an interesting take on investing offered by professional manager Mohamed El-Erian, the CEO and co-CIO of Pacific Investment Management Co. (the world's largest bond investor) in a June 11 interview with Jennifer Schonberger of The Motley Fool. In the interview he discusses the three elements of his new approach to investing for today's markets.

"The first element of the strategy is to be forward-looking rather than backward-looking.

'That speaks to asset allocation and geographical exposures,' El-Erian said.

The second element is that the road forward will be mired with sharp turns and bumps. As a result, investors must position their portfolios to benefit from cyclical trends.

'That bumpiness constitutes an additional challenge for buy and holds, which is to make sure that people can in fact hold -- because when you have a very bumpy journey, there is a temptation to stop holding at the wrong time,' he said.

'So there has to be a much more responsive element of the portfolio that is looking to capture not long-term secular and structural trends, but looking to catch shorter-term cyclical and technical trends,' he said.

The third element of El-Erian's plan is conscious risk management, which gets at diversification. In the past, El-Erian said, one of the problems with the buy-and-hold strategy was that it encouraged people to think that diversification was sufficient for risk mitigation.

'That's no longer the case. Diversification is necessary, but it's not sufficient,' he said. It's necessary because it's the best method for mitigation of risk, but it's not sufficient because, as El-Erian points out, you can have years, such as last year, in which all the correlations go against you. Therefore, he said, buy and hold needs to be supplemented with much more responsive risk management.

'It's not enough to say I'm going to be able to buy and hold simply because I'm diversified. One has to go a few steps further and ask what does it look like when I'm actually buying and holding?' he said.

Building on that, El-Erian said a portfolio should be constructed such that only part of it is held for the 'long term,' which he defines 'long term' [sic] as three to five years, max -- because it's difficult to forecast what happens much beyond that."