If you are to invest in the stock market, it is wise to have a plan, this guide to investing in 2012 should prove worthy as any. How do you invest in 2012? The key concepts remain the same, only the variables change.
In the event that market conditions were going exponential and doubling every year for example, you would invest everything you have and use leverage to do so. You would then try to find ways to borrow out equity in your investments, to borrow more. Real estate would be a great market for this as you can take out home equity loans as the value of your property rises, and use that loan to buy more properties and repeat the process on tremendous leverage. If instead the market was completely random, there is only one possible way to beat the market over a very long period of time, (assuming fees were negligible enough or non existent) and that is to own 50% cash and 50% stock, and to constantly rebalance to maintain this 50/50 split. If the market functioned as a perfect sine wave, you would start to buy as close as the bottom as you can, and sell as close to the top. You would buy and even get on leverage during the phases in which the line is the steepest (in the middle), and get off leverage when it starts to slow (near the edges). If the market went straight down you would sell short. If the market only went straight up, and then straight down, yet did so in a slightly unreliable way with a lot of seemingly “random” noise, you would want to keep mostly stock when in an uptrend, and when the trend wears down, mostly cash and shift to even more cash and possibly short in a confirmed downtrend. This covers all technical patterns of the overall markets aside from certain “shapes” and “bases” which are more relevant for growth stocks to identify periods where the uptrend has started and institutional funds have started buying, pushing the stocks upward yet not overbought. The pattern itself allows you to be a bit more specific.
The actual investment strategy should be a combination of all of these, depending upon which conditions most accurately reflect the current market place, but it should not be all done on technical analysis.
The analysis of the actual company is related to “future value” rather than current value, but the growth rates and prospects for growth (good management, high ROE, and a new competitive or dominant product in an emerging industry and ideally a consumer monopoly or other businesses having a high dependency on this product) only some of which are based on quantitative analysis (numbers) are important as well.
There is of course “value” investing, as well as growth investing and a combination of both. in both cases, price matters, and earnings matter. In value investing balance sheet and enterprise value matter, and in growth investing, the rate of growth and raising expectations of growth and increased growth in the future matter.
Growth investing and value investing both compliment each other. Understanding what effects the price of stock based on these concepts is important as well. For example, if a company earns $1 per share a year, then in 10 years if the earning accumulation is reflected and everything else is the same, it should be worth $10 more than today. If however the company grows from $1 to $1.1 per year and so on over that 10 year period, the company should be worth at least $15.94 at the end of 10 years. Further more, if the earnings held steady for the next 10 years, after growing the first 10 by 10% per year, the following 10 years it would be worth $23.58 more. More importantly, if the company grew 20% per year instead of 10% per year, it would be worth $25.96 in 10 years. If you try to price a company based on the yield which would be based upon the future value of the company, the growth expectations make a big difference. The future value depend on future earnings power of 10 years worth of earnings as an example, but perhaps less depending upon the time frame. (not a P/E of 10, or average PE over last 10 years, but the next 10 years worth of earnings from now). There is a huge difference if there are relatively small changes in perception of growth and actual growth.
The point here is that an upwards revision will drastically change the value of a company over night if that change in expectation and growth story is believed. Not to mention if growth accelerates. There are many ways to value a company. 1 is based on what you get out of it over 10 years. If you were to buy a company outright, say it’s like a piece of real estate worth $100,000 and you think you will sell if for $100,000. You can rent it out for $100. In 10 years you will get $12000 on your investment, and sell the house getting your initial $100,000 back. The earnings is all that matters in this case, as 10 years will be a 20% return on the investment. If the assets appreciate in value (the price of the house), or if the earnings appreciates in value (the rental income) there is another big difference in pricing. So even with a long term perspective, stocks if perfectly priced based on known information, and such information drastically changes the growth prospects, the value can change quickly.
Well it is very rare for a company to instantly reflect the changes completely efficiently. institutional funds may take weeks or even months to accumulate a position in a particular stock. As such, looking for either changes in expectations, or changing in fundamentals that will change expectations, or changes in the macro-economy such as liquidity and circulation and velocity of the money supply (as this will boost growth stocks) make a huge difference. Similarly, if the prospects for growth are too high, simple changes can make a drastic reduction in the value over a short period of time. Such as Netflix, for example. The growth investor determines 10 years of value. The value investor recognizes growth can change, so he focuses on the current worth of the company.
To understand the ideal way to invest in an environment of growth and value, the best way to explain is using an example of risk arbitrage plays. Say there is a 100% chance of a deal going through. While this is never the case, over 95% of deals went through (or have been delayed but have yet to be cancelled) in 2011. Arbitrage information that you need to know after announcement is much more “perfect” in arbitrage situations than in others. For example, say Coke buys Pepsi (ticker PEP). Say PEP is valued at 100 billion. Assume there are no laws against monopolies and nothing stopping them from growing through. Pepsi might agree to be bought out for say 110 billion dollars, a 10% premium. They estimate they will close in 3 months. The upside is known, the time frame is known.
Now you know not only your return, but you can calculate your expected annualized return if the deal goes through. You can estimate the probability of it going through times the loss if it doesn’t by the probability it goes through times the gain if it does, and then annualize that return and compare it to the other opportunities, if you want to be more accurate about your expectations. If you can return 10% every 3 months for a year, (4 times) that will be 46.41% when the proceeds are reinvested and compounded. Let’s say meanwhile there is another deal where it returns 3% every month for a year. If you take 100 times 1.03 and then you get 106.09 and multiply that by 1.03 for 12 total times, you get 142.5761 or 42.5761% more. This is less than the 46.41% but not by much. The market cap of Pepsi will most likely not rise at an equally spaced out amount per trading day up until the announcement occurs. Neither will “arbitrage B”. Additionally, if it is a stock merger deal rather than cash acquisition, the price of coca cola could change downward which may affect the buy out offer. $110Billion worth of Coke (KO) for example might represent a fixed amount of shares, but as the value of the shares change, so too does the value of the buyout. But to keep things equated to value, you want to further break down the price advancement needed per day both in fixed increments as well as percentage terms. If you are going to see a 10% return of 30 days, that is going to be 1/3rd of a percent of the current price per day. So at $100 per share, when the buyout offer is $110 per share, that represents 0.33 per day. Unfortunately it’s still not that simple. The market is not open every day, but let’s assume it is… if you expect the stock to rise an equal dollar amount, this is a small error because this will not always help you know when the annualized return increases and becomes more valuable than it started. So instead you must figure out the percent return that is the daily return that will result in the same annualized return. You can then have an “expected price” and see where you are at each day. Or each day you can recalculate the annualized return, or use a compounded annual growth rate calculator.
In the example “pepsi” or “arbitrage A” should increase by a factor of 1.00105 or about 0.10%. “arbitrage B” should increase by a factor of 1.00974 or about 0.10%. They are very close to the same, especially when using a calculator and breaking up a year return into a 365 day period. If instead we only include when market is trading or about 260 days, you get what is rounded to a 0.15% increase for pepsi or “arbitrage A” and a 0.14% increase for “arbitrage B”. Now even if the probabilities are the exact same, you will get no 2 money managers to agree how much of your assets should go into each opportunity. The reason is, you get different “risk” if you invest in these two, so although one may be clearly more valuable, there will always be value in investing assets in the other deal, so if one doesn’t go through you still have capital. It’s about your overall portfolio return over time, not expected value per trade. Additionally, if you think other better opportunities will be available, there is additional incentive to invest in the one with less time until the deal goes through. If you think better opportunities will not be available, you are better off locking your money up in the longer term deal.
However, one thing should be relatively clear. You generally want more money into the deal that is expected to yield more compounded annually if all things are equal, even more so as the return reaches greater extremes in differences between 2 deals. What I mean is, if you only had these two assets to invest in, and say Pepsi dropped tomorrow and “arbitrage B” didn’t, you would be more likely to put more assets into pepsi if you wanted a higher return. If Pepsi stayed the same and “arbitrage B” dropped, you would be more likely to want to put it into “arbitrage B”. You would still be putting some assets in both of these opportunities, but you would just put more money in the one with the higher return.
The reason I bring this up, is because part of the market’s function of pricing in value is weighing all other similar opportunities, and measuring the expected return over time. So explaining the functions of how a particular return is priced with KNOWN information, can better help explain what to change if the information is unknown, and also how the stock market functions as a value mechanism based upon expectations. What I didn’t mention is there are often revisions of how long the deal will take to go through and this will drastically effect the expected return. This change of expected return can create large capital shifts from one arbitrage opportunity into others. As a result, expectations of arbitrage opportunities will shift based upon expectations of the annualized expected return (after risk) of the particular deal.
There certainly are other considerations in value companies, as there are potentials for buy out offers, earnings growth and contractions. Also decreased competition and increased liquidity result in higher prices which means people are willing to pay the higher multiple than usual because there is more money to go around and less companies. But what is important is HOW you think about it, and that you still understand the key concepts of how the market’s pricing mechanism functions. If a particular investment is good but the company may be obsolete in 3 years, how does that change the “future value” vs something that is a slow and steady grower that will likely be here for a long time?
You definitely will want to balance out the risks, and make sure you don’t get exposed in any one direction, and make sure you understand your overall portfolio’s correlation to different aspects of various scenarios and the likelihood they play out. Ideally you don’t want to invest in a stock where any single event can wipe out your portfolio, and if you are exposed, make sure it’s an event that has an extremely low probability of happening, or seek to protect against that risk. That has everything to do with the principals of the kelly criterion, which is seeking independence on profitable bets to have a superior long term growth rate in your portfolio.
One final consideration is contrarianism. When the maximum amount of people that are going to buy an asset do, there will not be enough pressure to keep the asset going higher, same thing when there are the maximum amount of sellers to buyers, or selling panic. As a result, opportunities present themselves to buy assets that are being liquidated, as do those in betting against the popular assets that are going into a mania. More importantly, understanding contrarianism principals can help you identify areas to avoid that represent more risk than many realize, while considering areas that are lower risk because they have already sold off so drastically.
But back to the initial question, How do we invest, understanding what we know about the market?
This is both a science and an art. A mixture of both assets that do well in inflationary times (such as stocks) and deflationary times (such as bonds) and even sideways markets as well as mild bull and bear markets or inflationary and deflationary situations (neutral plays such as arbitrage). As the market is not completely random, you don’t want an even mixture. As the market trends, you want to use such trends as signals to change philosophy. You change philosophy, not by outright sells and buys, but increases and decreases of your percentage position size. Become more bullish when the trend has turned up or when the downtrend is at extreme oversold readings, and more cautious when the trend has played out and is overbought or starts a downtrend. Within each trend there are counter trends, or short term trends within the longer term trends. These can be used as opportunities to make more subtle and more minor adjustments, to play such trends and also be shifting when overbought, oversold or a new trend, or else, you can use such dips in the trend, particularly if they hit extreme points which may form a “trend channel” to “buy the dips” and “sell the rips” by increasing shares on lower prices, and decreasing on higher as long as the trend is intact. Additionally, it is important to be mindful of the longer term value and cycles, as well as the individual names you invest in should be appropriate for the given conditions and respect the concepts of value. Of course this is a very delicate balancing act.
Here is what I mean. If the monthly trend is down, which it is now, you would have more cash than stocks, unless the trend is oversold At monthly oversold, the shift is to bullish from cautious so you might shift to 50% stock, and making sure you risk more if weekly trend is also oversold, or starts an uptrend.
There are 4 conditions in each given trend extremes on monthly, extremes on weekly, extreme on both, or no extremes. Then there are 4 different directions
monthly trend up, weekly up
monthly up, weekly down
monthly down, weekly up
monthly down, weekly down
If you like, you can come up with percentages, but these should only be rule of thumbs or rough guidelines, not strictly followed. You might simplify things and say
Monthly trend up signal=add 50% to stocks or neutral trades
monthly oversold extreme=add 55% to stocks or neutral trades
weekly trend up signal=add 20% to stocks or neutral trades
weekly oversold extreme= add 25% to stocks or neutral trades
daily oversold signal= add 5% to stocks
Monthly trend down, monthly overbought, weekly trend down, weekly overbought and daily overbought would be the opposite, so you would add the same percentage to cash or bonds or neutral trades. You may wish to allow leveraged etfs in times that are above 50% bullish, or leveraged arbitrage deals, assuming other indicators are favorable. The principal is important, but the signals you use should prove to be somewhat accurate. If you have more accurate daily signals and are able to act upon them, you may wish to use those more aggressively.
Analyzing the trend can be a difficult, time consuming task, and there are more than one variable in whether or not there is a “trend” and actually deciding what to do with it will be challenging as well. Eventually I hope to provide a service where I will give you this data. For now, occasionally I will come up with a report each month for free, but it will not be this way forever.
In 2012, the stock market is more dangerous than usual. there are macreconomic factors that present significant default risk, drastic shifts in capital and currency, and the potential for events that may blindside some. As a result, I will advise perhaps adjusting your bias by at least 5% everytime to the bearish (cautious) side. However, historically oversold signals should be more respected than overbought signals in terms of timing, particularly in the RSI.
In 2012 the year looks to start with daily overbought (for now as of 12/29), and weekly overbought in a monthly downtrend So you would be 80% in cash and bonds. The momentum continuing upwards into this year is not surprising, but it would be if it continued much longer.Maximum caution is advised. Based on long term contrarianism, I would avoid bonds, particularly in the 2nd half of 2012 and I would avoid gold for most of 2012, or at least the first half. Real estate on the other hand may present a decent opportunity. The maximum selling pressure of homes will likely occur, and the foreclosures are hitting the books at the maximum pressure. However, there simply will not be much additional inventory for the time being, at least as a result of foreclosures, and the stable inventory which potentially may even decrease, could provide a multiyear flood, particularly if there is some kind of panic that hits in 2012 in the economy. Real estate is a very illiquid, leveraged based market so the actual prices may not behave so predictably. However, I suspect the confidence will begin to return over the next few years, and in many areas where foreclosures hit, you will have an opportunity to buy this year and next year, and potentially sell in a a few years into the peak of the next business cycle which could be around 7-11 years from 2007-2008 So late 2014 to early 2019, most likely around a target date of 2016 (11 years from 2005, which some say was the top in some aspects of the economy), and fits in the range of 2014-2019. Given the government’s debt levels, and the potential for shortfalls and spending cuts, or worse increased taxes specifically aimed at real estate, the liquidity will probably become a trouble a bit earlier.
Ultimately 2012 will be about maximizing opportunity and protecting gains as in any year, but the emphasis will be on protecting gains in early 2012. The principals may shift drastically in the middle of the year though if things get oversold and sell off drastically as Europe collapses and people fear the end and another great depression when prices will already be pricing in the risks and possibilities of such an event and liquidity is sure to return eventually.
Regardless, the plan for 2012, should be to increase exposure to “risk”, as stocks decline, (while decreasing “risk off” exposure) particularly in the more favorable areas (oversold extremes or coming out of oversold and in the early phases of a new uptrend), and to decrease exposure to “risk” (and increase to “risk off”). It should be to reduce the overall amount of correlation in your portfolio while still taking what seems to be profitable trades. In individual stocks, using principals of value and growth and understanding of an expected annualized return over a given period of time. You should weight your portfolio accordingly so that it tends to have more invested in the area that will produce the best annualized return (after taking into account the risks and potential downside and probability of such decline), and less in the ones with the smaller annualized returns over risk.
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