What's Your Sell Strategy Going To Be?

Good Morning. It is said that the definition of investing genius involves a short memory and a bull market. As such, anyone who has been long the stock market to any degree recently is probably feeling pretty smart right about now. Even after Friday's algo-induced hysterics into the close, the S&P 500 is up +20.5% from the November 15, 2012 low, up +48.4% from the October 2011 low, and has gained an eye-popping +141% from the crisis-low seen in March 2009. So, for those who were brave enough to buy the big dips (aka when there was "blood in the streets"), genius may indeed be the appropriate term to apply.

So, is buy-and-hope back? Should investors forget about market risk and just keep buying? And is a simple diversification strategy the real key to long-term success?

As to the question of whether the buy-and-hope approach to the stock market is back, the answer is yes and no. The bottom line here is the ultimate success of such an approach depends entirely on when you buy. If you, like Warren Buffett, have the ability to identify major turning points (give or take 10%) in the market and invest when everyone else is convinced that the sky is actually falling, then yes, buy and hold is a great way to go.

For example, had you bought in March 2009 when the consensus was that the credit crisis was going to destroy the global banking system and stocks were crashing, you would have been handsomely rewarded for your purchase. Yes, the ride has been a bit bumpy as there have been severe corrections along the way (-16% in 2010, -20% in 2011, and then -10% and -8% in 2012), but "buying right" definitely has provided rewards.

However, if you are not adept at knowing when to pull the trigger, your results may be dramatically different. For example, think back to the end of 1999. Stocks were roaring. Technology was en fuego. And analysts were inventing new ways to calculate valuations due to the "new era" of investing. But for anyone who decided to plunk some extra money in their stock funds on 12/31/99, the rewards have been quite different as the S&P 500 is up just 11% since the turn of the century. Oh and you had to stay the course during two devastating bear markets in the process in order achieve that return.

Take a look at the chart below. While this is clearly an extreme oversimplification, note the difference between buying when the market is "popular" (as indicated by the down arrows) and when there is "blood in the streets" (the up arrows).

S&P 500 - Monthly (9/99 - 5/13)

Another thing to understand is that most investors only use one-half of the "buy low and sell high" strategy. Most investors spend their time worrying about what and when to buy. And while "buying right" can clearly make you some good money over time, selling right - or at the very least, managing the risk in the market - can be equally as important.

This brings me to my big point this morning. Far too many investors (and this includes professionals) don't have a strategy, a system, or even a well thought out plan for selling. Ask yourself (and be honest): What's your sell strategy for the stock market?

It almost doesn't matter what strategy you employ. The key is that you need to have a strategy to manage the risk in the stock market. And with stocks sitting near all-time highs, now might be a really good time to think about developing a plan to exit the market the next time the bears come to call.

In the chart above, which is the S&P 500 using monthly closes, I've also included a very long-term trend smoothing signal (a 27-month weighted moving average, moved forward two periods). While I don't recommend this as a stand-alone system to enter and exit the market, you can see that following such a simple approach would have kept you out of trouble during the 2000-2002 and 2007-08 bear markets.

In fact, had one sold when the S&P 500 moved below its 27-month moving average and then bought when the S&P moved back above, you would have nearly tripled the return of the buy-and-hold approach (+79.4% vs. +27.1%). And you would have had to sell only 4 times since the end of 1999.

For more adventurous sorts, you could consider a strategy of being long the S&P when above the trend smoothing and being short when below. This approach would have been even more rewarding as the total return would be +124% versus +27.1% for buy-and-hold over the same period.

There are many, many sell strategies that are far more effective. One of my favorites, which I've written about several times involves using the Investor's Intelligence Sentiment Data as a buy/sell trigger. Since September 1970, a long/cash strategy would have produced an annual gain per year of +10.7%, which is far superior (46.6% better) to the +7.3% buy-and-hold return. And since 93% of the trades would have been profitable, it might make some sense to utilize the sell signals to enter a short position.

Then there is the strategy involving the health of the S&P's Sub-Industries (we break the S&P down by 10 sectors, 20 industries, and 104 sub-industries). The thinking here is to stay in tune with the technical health of the overall market. Since the fall of 1979, buying the S&P when the percentage of sub-industries that are "technically healthy" (i.e. above their long-term moving averages) exceeds 58 and then selling when the percentage of technically healthy sub-industries falls below 45 would have been very successful.

Using a long/cash approach to this strategy would have produced an average annual return of +15.3% per year for the period (9/1970 - 5/2013). This compares quite favorably to the +8.5% return for the buy-and-hold approach. Remember, at +15.3% per year, money doubles every 4.7 years (versus the 8.47 years for the buy-and-hold return).

And should you wish to take a more aggressive long/short approach, the average annual rate of return jumps to +18.3% per year (where money would double every 3.9 years).

For the record, the last two strategies are included in our Market Environment Model, as well as a shorter version of the longer-term trend smoothing approach shown in the graph above.

Looking at this long-term stuff, I often wonder why more investors don't knock the cover off the ball in their portfolios. As the examples I've shown prove, there are lots of ways to skin this cat. However, I think the problem for most investors is two-fold.

First, there is a general lack of knowledge on the subject of managing risk. Most investors bought into the buy-and-hope approach in the 1990's and simply don't know any other way. And then there is the other problem - we humans are emotional creatures that too often fall victim to fear, hope, and greed.

The bottom line is most investors can't sit through a decline of -20%, -30%, -40%, or -50%. So, during times like the tech bubble bear of 2000-02 and the credit crisis in 2008, investors get scared and they sell. Too many investors succumb to their fear as their stomach tells them things are bad. Thus, investors who sell when things are "bad" wind up doing the wrong thing at the wrong time.

And remember, the mathematics of loss is absolutely brutal. A 20% loss means you need a gain of 33% to return to breakeven. A 33% loss means you need nearly 50% to get back to where you were before the decline. And if you lose 50%, it means you will need to double your money to get back to breakeven. And given that both the 2000 and 2008 bear markets produced losses that approached 50%, it seems to me that it might be a good idea to have a plan to deal with the next bear market.

Instead of using emotions and selling at the wrong time, I'm going to suggest that investors admit they are human. I'm going to suggest that investors embrace the idea that stocks move up and down. And I'm going to suggest that investors forget buy-and-hold, and develop a plan to manage the risk of the stock market - as in now, right now.

My point this fine Monday morning is that it almost doesn't matter what your sell strategy is as there are any number of strategies that can dramatically enhance a buy-and-hope approach. The real key is to have a sell strategy and then stick to it. So, again ask yourself: What's your sell strategy going to be?

Turning to this morning...

Asian markets didn't fare well overnight as it was another really bad day in Japan (Nikkei -3.72%) and there some conflicting data out of China (the official PMI was better than expected while the HSBC version was not). However, the PMI's in Europe came in above consensus (albeit universally below the all-important 50-level), which has turned their markets from red to green. U.S. futures are following Europe and point to a rebound after Friday's late-day massacre.

Follow Me on Twitter: @StateDave

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

Posted to Investing 101 on Jun 03, 2013 — 8:06 AM
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